Chronicler foresees price tag for economic debacle topping $2 trillion

CORBIS/Richard Morrell

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.”

Charles R. Morris
Photo by Jennifer E. Morris
Charles R. Morris

“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.

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Comments (9)

  1. Submitted by John Olson on 09/23/2008 - 04:08 pm.

    Here’s another footnote to that Bloomberg story John:

    (Kevin Hassett, director of economic-policy studies at the American Enterprise Institute, is a Bloomberg News columnist. He is an adviser to Republican Senator John McCain of Arizona in the 2008 presidential election. The opinions expressed are his own.)

    I don’t necessarily disagree with what he offers, but it IS reasonable to say that the problems transcended well beyond Fannie and Freddie. And many of these events occurred in the same timeframe (2002-2006) when the Republicans had majorities in both houses of Congress. So it is a stretch from my vantage point to try and dump this solely on the Democrats.

  2. Submitted by John Olson on 09/23/2008 - 04:13 pm.

    And the summary of S.190 as prepared by the Library of Congress/Thomas Legislative is here:

  3. Anonymous Submitted by Anonymous on 09/23/2008 - 01:40 pm.

    Guess again who’s to blame for U.S. mortgage meltdown
    Analysts point not to greed, but to social activist politics
    Posted: September 19, 2008
    6:19 pm Eastern
    By Drew Zahn

    While many pundits are pointing to corporate greed and a lack of government regulation as the cause for the American mortgage and financial crisis, some analysts are saying it wasn’t too little government intervention that cased the mortgage meltdown, but too much, in the form of activists compelling the government to pressure Freddie Mac and Fannie Mae into unsound – though politically correct – lending practices.

  4. Submitted by True Lee on 09/23/2008 - 12:27 pm.

    Duh!!! Charles Morris isn’t the only person to have known this meltdown was coming. THE ONLY RULE ON WALL STREET, AND IN THE BOARD ROOMS, IS THAT AT THE END OF THE DAY THERE ARE LOSERS AND WINNERS. GREED IS THE ONLY STRATEGY TO WINNING THIS GAME. Our leaders in the corporate world and in Congress knew it too. If you look at the financial policies lobbied by corporations and passed by Congress like making it harder for people to declare bankruptcy, policies to enable credit card companies to set rates at their whim, or tax shelter loopholes to enable government officials, CEO’s and the rich to secretly shelter their money, you can see a pattern that these people knew what they were doing and what they were getting us into. Greed was insidiously taken to the extreme on Wall Street with the aid of CongresS. AT THE END OF THE DAY, THE AVERAGE TAXPAYERS (MAIN STREET) WILL LOSE AGAIN!!!

  5. Submitted by Bernice Vetsch on 09/23/2008 - 12:42 pm.

    Let’s hope this is not just a “body blow” to the Chicago School of economics but the coup de gras that finishes it off.

    Congress must not accept this punishment of the taxpayer for the sins of the Wall Street lawyers who helped Phil Gramm write the enabling legislation and the unscrupulous bankers and other lenders who took advantage of the opportunity to fleece borrowers. Sometimes, they falsified applications by overstating an applicant’s income and sometimes they told unknowing borrowers not to worry about the possibility that the monthly payments on their variable-rate mortgage would probably never change.

    Secretary Paulson’s scare tactics must not be allowed to work. Buy equity in firms, NOT bad loans.

  6. Submitted by Susan Oehler Seltzer on 09/23/2008 - 01:34 pm.

    Readers, please see reader comment to MinnPost’s first story of the Bear Streans bailout.
    TUE, MAR 18 2008 1:15 PM (Dave Beal)

    Where was our leadership early in the year, not informing the American public and devising a strategic plan to deal with this most critical issue to the US people.

    An understanding of derivatives and the basics of swap and counterparty risk, like Mr. Morris, has known, defines that the run on banks has been due to a ponzi scheme and there is no real value in these trades.

    The shorts are correct, they have every right to short the financials and that is our free market capitalist system working at its best.

    We asked our politicians to please pay attention, last March. Now, there is the potential destruction of our economy for many, many years to come, with no intelligent debate!

    The current administration is trying to rush through a plan with no details. Enough is enough.

    Our politicians need to buckle down and
    understand what is going on, if they are representing us in Washington.

    Our country, over the last few months, has needed a leader to stand up and take control of this issue. Senator McCain and Senator Obama need to
    have advisors that are explaining the reality of the situation. Perhaps they are, but I have yet to hear a presidential candidate express a true
    understanding of the issue and propose realistic solutions.

    It is politics as usual as we move down the road to destroy the value of the US dollar and explode our deficit. If we have two candidates running on”change” let’s hear how you are going to change things and demonstrate it right now as a role as a U.S. Senator.

    It is not change we need in Washington in January, it is change and intelligent, thoughtful leadership we need today and it has never been more critical to the American people.

    Dave Beal reports Economists just didn’t see it coming. Unfortunately it appears certain local economists had not been trained in derivatives, but there have been numerous economists, nationally, warning of this most critical pending time-bomb for our financial system since October, 2007. Don’t our politicians have staff that keep them informed about what economists are saying?

    The hearings in the Senate Banking Committee need to focus on how all counterparties involved in credit default swaps are going to unwind “the
    toxic synthetics.”

    The plan they are debating in Congress will not work, but will restore confidence in the markets temporarily, but will inflate our deficit for years to come and will not provide no resolution to the “toxic synthetic” issue hampering our financial system.

    There is a simple answer, involve all parties to the swap contracts, globally, to determine the “dollars” needed to unwind and cancel the contracts. It is unprecendented in this over-the-counter market,extremely difficult, but it is the parties that have created the mess taking responsibility for the mess they have created.

    Determine a dollar amount for resolution of the synthetics “ponzi” problem that has caused the run on Bear, Lehman, AIG. Once there is a dollar amount for unwinding the toxic, valueless synthetics, go back to Congress with a clear definition on the issue and what type of dollars
    the US government needs to employ to restore confidence in the global financial markets.

    Secretary Paulsen at his hearings this morning, says we will use transparency, but it is “so complex” that we can not define it in these

    It is not. The taxpayers should not agree to any bailout without a dollar amount and strategic plan for dealing with the toxic securities and
    separation of them from any thing that does have a real market value.

    Separate out the foreclosure issue from the “synthetic” ponzi, credit default swap issue that Mr. Morris talks about and has defined in his book.

    Define the real issue, even though it is somewhat an embarrassment to those on Wall Street and the current administration’s regulatory appointees.

  7. Anonymous Submitted by Anonymous on 09/23/2008 - 06:24 pm.

    FBI investigating companies at heart of meltdown
    Sep 23 07:11 PM US/Eastern

  8. Anonymous Submitted by Anonymous on 09/23/2008 - 02:04 pm.

    How the Democrats Created the Financial Crisis: Kevin Hassett

    “Oh, and there is one little footnote to the story that’s worth keeping in mind while Democrats point fingers between now and Nov. 4: Senator John McCain was one of the three cosponsors of S.190, the bill that would have averted this mess.”

  9. Submitted by Tom Poe on 09/23/2008 - 03:55 pm.

    Unfettered free market “pull yourselves up by your bootstraps” republicans, and that means the whole lot of them have forfeited their title to capitalism in a democracy. The fight is finished. Republicans will have to start from scratch. They are irrelevant, to be despised for the pain and suffering now, and in the next several years. Goodby and good riddance.

    Want to see what real capitalism looks like? Visit the site of Grameen Bank. Yes. It’s a bank and doing just fine, thank you. The model is social entrepreneurship. The idea is to require all corporations to include a nonprofit division that contributes to society. Easy. Simple. Reassures the Wall Street folks that financial system is stable. Want proof? Type in the term in your favorite search engine and get up to speed.

    So, knowing what we know now, there won’t have to be a bailout. There won’t have to be any more Republican crap shoved down the throats of Americans. And, our world is a better place, instantly. So, what do you suppose Paulson is up to? Is it possible, the Republicans are trying to bully their way to a going away present from Bush to cronies of $1 trillion dollars or more of our money? I do.

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