The Panic of 2008 - Contents

Experiencing the Financial Panic of 2008

1. Raise the Storm Signals
   
   
2. Economy: Roaring or Limping? You Make the Call
   
   
3. Soft Landing or Controlled Crash for Economy?
   
   
4. Mortgage Moms Feel the Heat
   
   
5. Real-estate Prices Bobble
   
   
6. Home Mortgage Market: Crash or Bounce?
   
   
7. Bernanke's "Rookie Mistake?"
   
   
8. Is It Over Yet?
   
   
9. Bush to Help Subprime Borrowers
   
   
10. Mortgage Mess Hits Real Economy
    
    
11. Fed Cuts by 0.5 Point
    
    
12. Fixing the mortgage crisis, but how?
    
    
13. The Economy: Now What?
    
    
14. Stimulus Plan Could Be Worse
    
    
15. To Ease or Not to Ease
    
    
16. Another Day Another Dollar
    
    
17. Too Big To Fail
    
    
18. Bernanke's ARM Assist
    
    
19. Free the Subprime Six!
    
    
20. More Capital Needed at Fannie Mae and Freddie Mac
    
    
21. Fannie and Freddie Hit the Buffers
    
    
22. Market Failure: Government is the Problem
    
    
23. It's the Debt Stupid
    
    
24. Close-coupled Character
    
    
25. Mr Potter is Buying!
    
    
26. March towards the Sound of Guns. Not.
    
    
27. Our Unserious Politicians
    
    
28. What is a Mortgage Worth?
    
    
29. At the End of the World...
    
    
30. "The Great Moderation" Did It?
    
    
31. It's the Solvency Stupid
    
    
32. Searching for the Answer
    
    
33. Sunspot Provokes Big Market Runup
    
    
34. After the Rescue
    
    
35. Good News on the Economy!
    
    
36. An Obama Market Panic?
    
    
37. The Rest of the Credit Story
    
    
38. Bail-out for the Banks but not for Detroit?
    
    
39. Market Shrugs Bank Announcement
    

NYT Still in Denial on Fannie Freddie

One of the things you need to believe if you are a card-carrying liberal is that it was greedy bankers that caused the Crash of 2008, not government housing policy.  At The New York Times they have written nary a discouraging word on the subject.  They don't want their readers to find out that it was the Community Reinvestment Act that bullied bankers into making sub-prime loans and Fannie and Freddie that securitized them.

Lately, things have been a bit precarious, because Gretchen Morgenson, an NYT reporter, wrote Reckless Endangerment with Joshua Rosner.  It dared to point the finger at folks like former Fannie CEO James A. Johnson, former campaign manager to Fritz Mondale.

But good old faithful Joe Nocera is still plugging the Who Me? line.

Fannie and Freddie got into subprime mortgages, with great trepidation, only in 2005 and 2006, and only because they were losing so much market share to Wall Street... The reality is that Fannie and Freddie followed the private sector off the cliff instead of the other way around.

Peter J. Wallison, who wrote a dissent to the Financial Crisis Inquiry Commission, contests Nocera, arguing that Freddie mis-reported the number of its sub-prime loans for years.

Anyway, if Fannie and Freddie were late to the party, how come that they are in receivership, expecting to cost the taxpayer something like $200 billion in losses, when "Wall Street" is back up and running.  It suggests that the Fannie Freddie balance sheet was a lot worse that the average megabank.  And why would that be?

And if you want an insider look at Fannie and Freddie, this extraordinary call to the Rush Limbaugh radio program from "Laurie" might give you a clue.

xYou know, in the late '90s and early 2000s when real estate prices were sharply on the rise, you know, anywhere between '99 and '03 depending upon what part of the country you lived in, housing prices were on the rise dramatically, and there was a lot of pressure at Fannie and Freddie to get mortgages out the door.

We had a representative from FHA, HUD, Fannie and Freddie, all of which visited this mortgage broker's office. And when Fannie began this idea of packaging these things as securities and grouping them together, you'll find that the number of mortgage brokers for residential mortgages in the country skyrocketed because they were suddenly getting what we call wholesale lines of credits from banks. So mortgage company A or B goes to the bank and he gets a $15 million line of credit called a wholesale line. He fills that line up with mortgages and then they're guaranteed, they're bought off. Fannie and Freddie buy them up immediately, repackage them, or leave them whole and send them out to places like Lehman Brothers.x

Pressure at Fannie and Freddie?  To get mortgages out the door?

The problem with our liberal friends insisting that there is nothing to see here is that it blinds them to what is really going on in the world.  When you refuse to credit news that you don't like, there is a penalty.  One day you wake up and find that you have been totally blindsided.

Market Shrugs Bank Announcement

This is when you start to worry. The Obama administration announces its determination to shore up the banks, and the market shrugs. Well maybe the market will think it over.

According to Binyamin Appelbaum the government is easing up on the banks.

The federal government will ease the terms of its investments in more than 350 financial institutions to increase the benefit of the taxpayer dollars while reducing the cost to the banks, regulators announced this morning.

"The government will ensure that banks have the capital and liquidity they need to provide the credit necessary to restore economic growth," said a joint statement issued by the Treasury Department, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency, Office of Thrift Supervision and Federal Reserve.

Hmm. Things must be worse than we thought. So now the market is saying that we need more than joint announcements. We need concrete actions that demonstrate the administration’s determination to heal the credit system. Talk won’t do it.

Here’s a suggestion. Kill the stimulus bill and kill the bailout of the ten percent who can’t afford their mortgages. Before we butter up the Democratic faithful we’ve got to get the banks right side up.

You begin to see the cost of the Obama administration’s first month when it concentrated on sluicing money at its base instead of hitting one out of the ballpark on economic recovery.

The economy is, to an extent we don’t always appreciate, is a question of confidence and trust.

Yet everyone thinks that businessmen are crooks. We can thank the great political ascendancy of the last century, the progressive educated elite, for that. They have written in a thousand books and a thousand movies that businessmen are crooks and only progressive politicians really care about people.

Well, they are wrong. Business is, more than we know, built on trust. In business, you do whatever it takes to deliver good product to the consumer. And politics, as we’ve always suspected, is built on ruthless fighting and competition for the levers of power. You do whatever it takes to get elected. Notice the difference.

As the Obama administration plays out, we will see how much this fundamental misunderstanding of the nature of business and economic activity will mitigate the success of President Obama.

The problem is, of course, that when the politicians screw up, the people get to pay for their mistakes.

Bail-out for the Banks but not for Detroit?

If we can spend $700 billion on a bank bail-out why not spend a measly $25 billion on the auto companies?

The simple answer is that we can’t let the banks go broke. We tried it, sort of, back in September when Lehmen Brothers went belly up. The fallout from that nuclear explosion is still irradiating us.

But the bankrupty of an industrial corporation is not so bad. The railroads went in and out of bankruptcy with regularity in the 19th century. And the world didn’t end when the Penn Central went bankrupt in 1970 (in a recession, of course). Corporations go bankrupt when they run out of equity. In crude terms, the stockholders get handed their heads and the bondholders get to own the company.

When you look at the balance sheet of General Motors, today, November 18, 2008, you see Total Assets of $110 billion, Total Liabilities of $170 billion, for a Total Equity of minus $60 billion. That negative equity is mostly an Accumulated Deficit of $61 billion. No much to go on.

The best solution for General Motors is to go into bankruptcy. Then the creditors can get together and decide what to do to get something out of the wreck. And then the politicians could decide what they would be prepared to do to help out. General Motors could keep operating, of course, during all this.

A lot of people are going to have to take a haircut over the failure of General Motors. Right now, too many of them are still in denial. So they won’t agree to a haircut until General Motors actually goes broke.

The haircut can’t start until General Motors declares Chapter 11.

The Rest of the Credit Story

Here in the US we are naturally concerned about the damage that the mortgage meltdown has done to the domestic US economy.

Just on cue, as the federal government announced a 0.3 percent decline in real GDP last quarter, the stock market this week seems to a have turned a corner, starting with a 900 point climb in the Dow in the aftermath of the short squeeze on Volkswagen stock.

Don’t look now, but when the US catches cold the rest of the world gets wiped out. The Asia Times columnist Spengler has the story.

The financial crash exposes the fragility of large swaths of the world. The political consequences will be terrible... Worst affected are the most populous Muslim countries, and Russia’s "near abroad".

In the US we have had a credit squeeze. But you can still get a mortgage to buy a house. In the rest of the world the credit faucet has been completely turned off, and many emerging countries are facing economic Armageddon as their currencies tank. Spengler uses the cost of five-year default protection as a gauge of just how bad things are going to get. For countries like Argentina and Venzuela, it’s not available.

The solution is pretty obvious. The US is going to have to use its credit to bail out not just the banks but a number of nations, especially including the countries that escaped recently from the old Soviet Empire. Already the Fed and the IMF are working to spread money out around the globe.

[Treasury Secretary] Paulson said he welcomes the Fed’s decision to create swap lines with four central banks as well as the IMF’s decision to establish a short-term liquidity facility to provide various countries with loans. The Fed Wednesday announced swap lines totaling up to $120 billion with Brazil, Mexico, South Korea and Singapore.

Let’s propose that the bank bailout is working, that the major credit markets in the US and Europe are returning to normal as LIBOR rates decline from the mid 4s to the mid 2s.

That is fine and dandy. But the rest of the world is still completely frozen. The next step is to help them.

Because it doesn’t do the US any good if the rest of the world suffocates on a total credit seize-up.

And it also looks like the gleeful reports of the end of the US hegemony were greatly exaggerated.

An Obama Market Panic?

Are the markets panicking at the prospect of an Obama presidency and his presciption of more spending and higher taxes? Or are they just panicked?

The New York Post advanced the Obama Panic meme a while back, but I think that the panic is more about the fact that we are heading into a pretty nasty patch of economic weather.

And the markets sense that the politicians really haven’t a clue what to do about it. Let’s be frank. If McCain wins in November he’ll want to lower tax rates. And if Obama wins he’ll want to send out tax rebates. How about something we can agree on: tax rate cuts for corporate taxes? How about a cut from 35 percent to 25 percent?

Just as big as the Obama uncertainty problem is the fact that nothing will get done until the new president and the new Congress take office in January.

Here’s an idea from good old J.P. Morgan in the 1907 Panic. He did triage on the companies asking for a bailout. If he figured that the company would survive anyway he refused to extend credits. If he figured that the company would fail anyway, he refused to extend credits. But if he figured that the company could survive if he gave them a loan then he did.

Do you imagine that the new president and the new Congress could rise to something so practical and sensible?

I have my doubts.

Good News on the Economy!

Yes, I know that it’s the end of civilization as we know it. But there are some portents out there telling us something different.

First of all there’s Libor. That’s the London Interbank Rate, the interest rate that banks charge each other on interbank loans. Remember, the big problem in the current crisis is that banks are afraid to loan money to each other. Well, here’s the trend in in Libor and longer term interbank rates in recent days from Bloomberg.

10/17/08 10/20/08 10/21/08 1-month 4.18% 3.75% 3.53% 3-month 4.42% 4.06% 3.83% 5-yr Bank 6.36% 6.35% 5.84%

So that’s all right. The Libor rates are dropping like a stone.

Then there’s the news from the housing market in Southern California. Home sales were up in September by a record 65 percent. Daniel Taub from Bloomberg reports.

Southern California home sales rose 65 percent in September, the biggest year-over-year increase in at least two decades, as buyers took advantage of foreclosures to purchase properties at discounted prices, MDA DataQuick said.

Why is this important? Let’s hear from Ludwig von Mises, conservative economist and RMC Chappie. He wrote that a recession is the period of liquidation of the malinvestments of the previous boom.

But when the liquidation ends, then it’s time to start a new economic expansion. So the quicker the liquidation proceeds the sooner we’ll get to the other side.

Things are really looking up. Why, the economy may turn around and start expanding by January 20, 2009 when President Obama takes office. And then he can take the credit for the improved economy. It will happen on his watch, right?

After the Rescue

It looks as though the US Cavalry made it on time, and that Americans and indeed the people of the world will be spared a total financial meltdown. The stock market (which is the present value of the future earning potential of the economy) rocketed up yesterday and looks like it is taking a breather today.

But that doesn’t mean that we’ll be spared the actual experience of Ludwig von Mises’ definition of a recession: the period of liquidation of the malinvestments of the previous boom. There was plenty of boom until last year and plenty of malinvestment. Now we have to sort through the wreckage.

The good thing is that we are well along in the liquidation of the mal-invested houses of the housing boom of the 2000s. But there is probably a lot more out there that we haven’t seen yet.

After months of stumbling and bumbling, it looks like the world geniuses have come up with a plan to refloat the hard-aground banks. But obviously people are going to need to be rebuilding their balance sheets. That’s a euphemism for cutting spending.

Going forward, it would be nice if we learned something from the current credit crisis. And that simple something is that too much leverage is poisonous.

The chap who’s borrowed too much is an anti-social person who aims to make a killing if things go right, and walk away from a gigantic mess if things go wrong. That is wrong, any way you look at it.

Debt is debt. It ought to be secured and it ought to be limited. If you want to take a risk with Other Peoples’ Money then there is another way to go. It is called equity. When you borrow money you promise to pay it back, principal and interest according to a contracted schedule. When you buy shares in a partnership or a corporation you agree to share the profits and share the losses.

If you liquor—er, leverage—yourself up then you are likely to become financial impaired and unable to meet your obligations. If you confine your risky behavior to equity plays then you can always meet your obligations because you have just said that you agree to sharing in the risk of the enterprise.

This isn’t rocket science, is it?

Sunspot Provokes Big Market Runup

If anyone needed to know what drives the stock market, this last weekend should have sealed the deal.

Last weekend the first decent sunspot in Cycle 24 emerged. Here’s a breathless report from Watts Up With That. SolarCycle24 gives comprehensive data on all the sunspots thus far in Cycle 24.

As usual the traders got an early look at the data and Wall Street soared 7 percent in late trading on Friday to close down a mere 1.5 percent on the day.

The sunspot was waxing all weekend. What could it mean? The outcome was obvious. Today the Dow soared 11 percent in the largest point gain ever and the fourth largest percentage gain ever.

Are you convinced now? Come on now: what would it take?

Searching for the Answer

Everybody is searching for the reason for the meltdown and confidently trying to dig up the answer.

Here on Road to the Middle Class we’ve been as confident as anyone.

Jerry Bowyer has taken a look and his candidates for “the reason” include:

1. The Community Reinvestment Act which has forced the banks to make loans to deadbeats
   
2. Fair value accounting, which has wiped $500 billion in assets off the balance sheets of the banks.
   

You can point the finger at the crooks at the banks, and why not. There’s probably enough crookery in there to suit every taste. But the problem when you are searching for a reason is that, of course bankers start to cheat when things go south. They are embarrassed. They feel guilty. They try to hide their mistakes. Politicians like Sen. Christopher Dodd (D-CT) and Congressman Barney Frank (D-MA) do that too. It’s like people and sex. Remember? Everybody lies about sex.

But Bowyer wants to point out the effect of wiping $500 billion off the banks with fair-value or mark-to-market accounting. With fractional reserve banking, where one dollar in capital is needed to support 10 dollars in loans, the write-off has wiped out $5 trillion in credit.

$5 trillion in credit? That could make quite a difference.

It's the Solvency Stupid

Monday and Tuesday the stock market tanked, and today it’s been on a rollercoaster. It was down as much as 2.5 percent and up as much as 2.5 percent, finally ending down 189.01 points on the Dow. You could say that buyers and sellers are fighting over the future. Will the bank bailouts here in the United States and in the United Kingdom do the trick, or is the poison too strong for the present antidote.

Let’s not forget that this is not a liquidity crisis alone. It is a solvency crisis. What are those assets worth on the balance sheets of the banks? Nobody knows, and that’s why the Feds are going to buy the bad apples from the banks. Clean up the balance sheets and you clean up the crisis.

Should we really be frightened? Is this 1929 all over again (or more properly 1931, half way down)? Or is it worse than that? Tony Blankley helpfully suggested that it could be the Black Death when one third of the population of Europe perished.

We humans are hopelessly optimistic—except when we are hopelessly pessimistic. There’s always light at the end of the tunnel, except when we are trapped like rats in a maze.

It has to be that way. After all, we are all going to die. It’s one hundred percent guaranteed. So unless you are hopelessly optimistic you might be tempted to say: What’s the Point.

And what’s the point of that?

"The Great Moderation" Did It?

Is there no end in sight? Today the market nosedived in the final hour of trading on Wall Street with the Dow off 678.91 points.

David Strom thinks it was the Great Moderation that did it.

Ever since the nail-biting recession of 1980-82 the world economy has been remarkably crisis free. There have been all kinds of things thrown at it: “the Savings and Loan Crisis, the ‘Asian Flu,’ the Russian default on their debt, the bursting of the dot com bubble and even the September 11th attacks.” But nothing was disruptive enough to cause a major recession. The global economy just sailed through.

Well maybe that golden age is over. People got used to moderation and in response took on bigger risks. We’ve all cashed in by taking out bigger mortgages and the folks of Wall Street have indulged in a veritable orgy of debt and leverage.

Not to be outdone the politicians geared up Fannie Mae and Freddie Mac to loan money on sub-prime mortgages in what you might call the granddaddy of all bigger risks.

Well, now it looks like the chickens are coming home to roost, with the Paulson bailout unable to arrest the downdraft in the stock market. Only, of course, the chickens are going to be roosting on you and me, not on the politicians and bankers that took the risks and awarded themselves the bonuses.

I suppose it’s too much to ask, but when we get out on the other side of this, could we try to reduce the amount of debt in the economy and try a little equity? It seems to me that it’s more neighborly, as it shares the gains and the losses, rather than grabbing all the wins for me and socializing all the losses for thee, as occurs under the current system.

Obama, ACORN, and the Smoking Gun

Here’s the story so far on the mortgage crisis.

In the 1970s the Carter Administration passed the Community Reinvestment Act that encouraged banks to lend in low-income areas. In the 1990s the Clinton Administration pressured banks to make sub-prime loans by holding up bank mergers for banks that didn’t pour enough money into low-income areas. In the 2000s Republicans tried to reform all this by reducing the exposure of Fannie Mae and Freddie Mac to sub-prime mortgages but Democrats cold-cocked every attempt at reform.

Now comes the smoking gun. It was ACORN, the left-wing group, through an inside/outside strategy of street pressure and lobbying pressure that was the driving force behind the mortgage mess. And Barack Obama was right in the middle of it in the mid-1990s, according to Stanley Kurtz in National Review.

“You’ve got only a couple thousand bucks in the bank. Your job pays you dog-food wages. Your credit history has been bent, stapled, and mutilated. You declared bankruptcy in 1989. Don’t despair: You can still buy a house.”

That’s what the Chicago Sun-Times wrote in April 1995. And how could it be that a dead-beat could get a loan? ACORN would help you batter down the doors of that evil bank.

That same year, as a director at Chicago’s Woods Fund, Obama was successfully pushing for a major expansion of assistance to ACORN, and sending still more money ACORN’s way from his post as board chair of the Chicago Annenberg Challenge. Through both funding and personal-leadership training, Obama supported ACORN. And ACORN, far more than we’ve recognized up to now, had a major role in precipitating the subprime crisis.

So we understand this. Back in the 1990s the celebrated moderate and post-partisan Barack Obama was sluicing money at ACORN’s far-left projects on housing and Bill Ayers far-left projects on education. Ayers, remember, was just someone Obama knew in the neighborhood.

Kurtz tells the whole story. It began with ACORN pressuring the local banks in Chicago. But pretty soon it came up against the reluctance of the banks to hold sub-prime mortgages; they couldn’t get them off their books because Fannie and Freddie wouldn’t buy them.

So ACORN went to Washington to pressure the adminstration and Congress to change the rules on Fannie and Freddie to make them accept sub-prime mortgages. They had modest success with the Bush 41 administration and major success with the Clinton administration. Bigger and bigger the balloon got, until one day, it popped. Oh dear. Must be those evil Republicans, eh, Speaker Pelosi?

So now we know.

Up to now, conventional wisdom on the financial meltdown has relegated ACORN and the CRA to bit parts. The real problem, we’ve been told, lay with Fannie Mae and Freddie Mac. In fact, however, ACORN is at the base of the whole mess. ACORN used CRA and Democratic sympathizers to entangle Fannie and Freddie and the entire financial system in a disastrous disregard of the most basic financial standards. And Barack Obama cut his teeth as an organizer and politician backing up ACORN’s economic madness every step of the way.

No doubt Sen. John McCain (R-AZ) will be mentioning this at the debate tonight in a mild and avuncular way.

At the End of the World...

With stocks down seven percent in Europe and the United States today, it looks like the end of the world, and maybe it is.

But maybe it is just a problem of too many people borrowing too much against too little in assets. Or setting up their lives without any thought for the downside.

There’s a simple fact about borrowing a ton of money. Things better work out for you, otherwise you’ll be wiped out.

From time immemorial financial intermediaries like banks have operated in a highly leveraged way, borrowing and lending a lot of money. Problem is that when the assets securing the loans start to go south then so does the bank. And that is what we are seeing now.

The problem right now is that market participants lack confidence that the other party to their transaction is going to be there next week. So they are reluctant to lend to them. The central banks are running around hosing everyone with money but so far this hasn’t solved the problem. There are still a lot of people with assets securing loans that are worth a lot less than they were last week, last month, or last year.

The solution is fairly simple. All these folks who are leveraged up to the gills and beyond are going to have to be rescued by companies that aren’t leveraged up to the gills. That’s what J.P. Morgan did in 1907. He took the questionable assets of a highly leveraged broker and swapped them with the gold bonds of much-less-leveraged US Steel. All of a sudden the broker’s loans were secured by an asset that everyone could trust, and US Steel had an asset that turned out to be worth a lot more that people feared.

Unfortunately this time around our genius leaders haven’t yet decided how to do this. We must hope that they hurry up and figure it out. It’s their job to do stuff like this, after all.

What is a Mortgage Worth?

Enough of the partisan political rhetoric, already. Let’s think about the big problems.

And the biggest problem right now is to figure a correct value for the great big ugly mortgage assets on the balance sheets of our beloved financial institutions.

That’s the big problem because, until we all feel confidence in the value of the banks’ assets, we really don’t know whether the banks are solvent or not. And nobody wants to have exposure with an institution that might be insolvent.

In a sensible article in VOX, economist Daniel Gros takes a stab at answering this question.

The important fact to understand, Gros states, is that US mortages are “no recourse” loans and that homeowners in conseqeunce have a “virtual put option.”

With a “no recourse” mortgage, the debtor effectively receives a virtual put option to “sell” to the mortgage-issuer the house at the amount of the loan still outstanding. Mortgage lenders are “short” this option, but this is not recognised in the balance sheets. In most cases, the balance sheets of the banks report mortgages at face value -- at least for all those mortgages on which payments are still ongoing.

This fact is implicitly understood by modern homeowners. The understanding is communicated in the popular term “jingle mail.” If things turn south and you can’t make the payments on your home mortgage you can always pull up the moving truck and mail the keys to the bank, which gets a nice jingly package in the mail next morning.

The question for Gros is: what is the value of the jingle mail option? It turns out that it’s bigger than you think.

Applying the usual Black-Scholes formula to a typical subprime loan with an LTV ratio of 100% yields the result that the value of the put option embedded in the “no recourse” feature is 26.8% of the loan, even in the low volatility case. For a conforming loan (a loan that could be insured by Fannie or Freddie) with a loan to value ratio of 80%, the value of the put option would still be close to 14% (still in the low volatility case).

Oh goodie. The Black-Scholes formula. That last reared its ugly head in the tech-startup stock options meltdown.

So the moment that a bank issues a subprime loan it ought to book the loan on its balance sheet at 26.8 percent less than face value. And even with a conforming loan where the homeowner has put down a 20 percent down payment, the bank ought to book the loan at 14 percent less than the face value of the loan.

You can see that this would make a huge difference. We simply wouldn’t be in the current liquidity crisis if the rules that Gros proposes had been followed. Of course, we wouldn’t have had the massive credit bubble either, because if the bank has to book a loan at 20 percent off face value then the multiplier effect of high leverage doesn’t apply any more.

Well, ok Dems. OK Barney Frank. OK Sen. Chris Dodd and the Friends of Angelo. Here’s the answer!

Ahem. Of course, you realize that the lovely stealth social program of sluicing mortgage money at inner-city voters would get caught in the meat-grinder if this rule were enforced upon the banks and Fannie and Freddie. And that would never do.

Our Unserious Politicians

Today the unserious House of Representatives punted on the administration’s plan to empower the US Treasury to buy toxic mortgage debt, get it off the market, and get the financial system going again.

It doesn’t really matter how it’s done.

This is not that hard to understand. When you have a bunch of debt floating around that’s under water—where the assets that provide collateral for the debt are worth less than the face value of the debt—then you have a problem. It’s like the game of musical chairs. Nobody wants to be left with the toxic debt when the music stops, so nobody gets up of their chairs at all.

It doesn’t matter who’s to blame for all this. It seems that there’s plenty of blame to go around, although it is important to realize that the banks, even the investment banks, are all regulated by the government.

We’ve got to get the toxic debt off the market, and these days that means the government.

A hundred years ago, before the Federal Reserve System, it was up to banker J.P. Morgan to direct operations during the Panic of 1907. And he did it. The key moment, as we have written here, was when the brokerage house of Moore & Schley was about to fail. Morgan engineered an asset swap to save Moore & Schley, got President Roosevelt’s approval, and the crisis was over.

If only we could do the same today. But the problem today is that the government has distorted the credit system in countless ways to support its various political agendas. That’s what the flap over Fannie/Freddie is all about. Congress decided to use Fannie/Freddie to boost homeownership in the inner cities. Great idea, and all that, but they didn’t want to pay for it. They wanted the banks to pay for it.

Well, now we are finding out the true cost of this stealth social program, and it ain’t going to be chump change.

March towards the Sound of Guns. Not.

Back in the good old days, when armies marched on their feet rather than Humvees, they had a simple saying: “March towards the sound of the guns.”

The reason is pretty simple. Under normal conditions, armies are scattered across the countryside. The key skill for an army commander is to get all his units to the battlefield before the other chap.

Of course, in real life there are units marching around, or camped, who haven’t got the word. But if they got to the battlefield then they could help. Indeed, they might make the decisive difference between victory and defeat.

So when Sen. Barack Obama (D-IL) declined to go to Washington DC to help in the final stages of putting the Great Mortgage Bailout Act together, he was violating this fundamental principle of conflict. Whaddya mean, call me if you want me?

A guy who wants to be president should be feeling: “I just can’t wait!” He should be foaming with impatience to get to work and solve the nation’s problems, to get into the room where critial decisions are being made.

But no. Sen. Obama elected to stay in Florida preparing for the presidential debate on foreign policy. Foreign policy? How about acting like the leader of your party and corralling senators and representatives together to get a solution to the nation’s economic crisis?

It goes deeper than that. Back to the military metaphor. Suppose you were a young, untested formation commander. You hear the sound of guns. What do you do? You march towards the sound of the guns. Here, at last is your chance to show the old buffers what you are made of. Here is the chance to deploy your troops and smash into the tired enemy troops that have been fighting all day. Here is your chance to show that you are made for greatness—and there may never be another chance.

If I were an Obama supporter, I would have a nasty feeling in my stomach today.

Mr Potter is Buying!

Remember the run on the Bailey Brother Building and Loan in It’s a Wonderful Life? Just as the panicky depositors were demanding their money back from George Bailey, Mr. Potter the evil banker called George in for a chat. You don’t really want that broken-down old Building and Loan, do you, George, he said, and all the bother involved?

Mr. Potter would buy it, he said, and George could have a nice job at Potter’s bank.

Don’t you realize! George yelled at the panicky depositors. Don’t you realize that while you are selling, Potter is buying?

Today, as John McCain suspended his campaign to get back to Washington DC to work on the bank bailout plan, Warren Buffett signed up for $5 billion of stock in Goldman Sachs.

Mr. Potter is buying.

Close-coupled Character

I was commenting on the financial meltdown of 1907 at the American Thinker today. It’s all about sound collateral, I argued. An alert reader complained about the loose ends lying around.

Back in 1907, you see we, had a major credit crunch with trust companies failing all over the place. J.P.Morgan solved it with a bit of asset swapping, so that a shaky Wall Street broker could have collateral that everyone could trust.

In the aftermath of the crisis Congress hauled banker Morgan up to testify so that they could convict the innocent and let the guilty go free. He rather surprised them by saying that the key thing in business is character. Very good. But I then muddled things up by talking about the danger of close-coupled systems. They are bound to break, sooner of later, and then where are you?

You are right where we are today.

Morgan also flummoxed his congressional interrogator by failing to explain why he would buy a stock like Equitable Life, which only yielded one-eighth of a percent.

The answer, I think is character. We can’t just have people running flat out everywhere, trying to get the last ounce of profit out of the economy. That goes for politicians like Barney Frank who want Fannie and Freddie to squeeze the last ounce of credit into “affordable” homes for Democrats. And it goes for Wall Street Masters of the Universe leveraged up to the eyeballs squeezing the last ounce of profit out of the latest hot stock or derivative.

What is needed is some men of substance around like Morgan who, from painful experience, are willing to provide a factor of safety for the economy. They buy a stock not for its immediate potential but because it needs a good home. They unwind their leverage because they don’t want to be wiped—or wipe others out—if they bet wrong.

With chaps like Morgan around, you hope to avoid the risks of the close-coupled system which, when it fails, fails big.

It’s a tricky thing to implement, because we all want more efficiency in the economy, and more efficient use of resources. But how much should we risk for that?

It's the Debt Stupid

So here we are, we hope, at the selling climax of this bear market, with the big Wall Street investment firms going cap in hand to the Feds and to the banks for a handout. Last night there was talk that Morgan Stanley and Goldman Sachs might be the next to go.

As Robert Samuelson says, this is the end of Wall Street as we know it. It is the end of the Masters of the Universe and their leverage fueled “principal transactions.” In the old days, investment firms worked for their clients. But now they work for themselves.:

Now, most financial firms also invest for themselves. They use partners’ or shareholders’ money to place bets on stocks, bonds and other securities — so-called "principal transactions."

And most of this investing has been financed with a high level of borrowed money. Nothing wrong with that, of course, until things go south and the asset that is collateralizing the loan can no longer liquidate the loan.

The trouble with high-leverage investing is that it is taking money that is not really supposed to be risk capital—i.e., fixed-income debt—and then using it in high-risk transactions. The banks or individuals supplying the money for this activity are not hands-off investors. They are risk partners in the venture. Because if asset values go south, then they are out of the chips.

For too long, for far too long, government has allowed this high-octane, highly flammable business model to operate, when everyone should know the risks. People investing money in these high-risk ventures and people lending money to these high-risk ventures are, whether they like it or not, risk partners in the venture. They should be treated as such and rewarded as such.

When you are a partner in the risk, then you should be getting an equity stake in the venture, not you should not be lending money backed by collateral.

How hard is this? Well, I’ll tell you. If we enforced this rule, that risk=equity and should be capitalized as such, then the Masters of the Universe wouldn’t be making so much money in the good times. They would have to share the wealth with their equity partners.

But on the downside they wouldn’t be forcing fixed-income investors and taxpayers to pay for their stupid mistakes.