THE BUSINESS OF AMERICA IS BUSINESS, Calvin Coolidge famously declared in the 1920s. But the business of America largely has become finance. Eight-plus decades later on, the material well-being of the nation depends not so much on what it makes and sells but in moving money.
As the first anniversary of the credit crisis approaches, one wonders how this happened. The so-called Robber Barons of a century-plus ago built their fortunes on industries that built America -- railroads, steel, oil. The great financiers of the time, such as J. Pierpont Morgan, helped build those industries. Finance then was called the handmaiden of commerce.
When did those roles reverse? If I had to pick a point, it would be somewhere in the 1970s. American industry, which once seemed invincible, suddenly seemed vulnerable, even inept. Innovation shifted to financial markets -- and not via Wall Street. The revolution came from points West, in Chicago and beyond.
As financial markets became deregulated and computing power became cheap and ubiquitous, all sorts of new investments burst forth. Nowhere was this more dramatic as in the mortgage market, because no instrument is close to being as complex as a mortgage in the U.S.
In general, Americans have had the right to pay off their home mortgages at their option and with minimal cost. In the home of the brave and the land of the free, you had the right to pick up stakes and head wherever opportunity beckoned. That's part of the American character.
In reality, most mortgages got paid off early for less heroic reasons. Americans tend to move every seven years. They get a new job or need bigger digs. Or they divorce or die, and the house gets sold.
That was before interest rates were deregulated in the 1970s and become high and volatile. When mortgage rates came down, homeowners exercised their option to prepay and refinance into a cheaper loan. The bond market rallies and your monthly nut comes down. Or you can afford a bigger loan and can "cash-out" to pay for renovations, a vacation home, cars, vacations or tuitions. Money for nothing, literally.
The option to prepay a mortgage was, in fact, an option in the financial sense. And since the Black-Scholes model was conjured in the 1970s, the value of that option could be valued just as options on stocks were valued. Just plug the data in the new, cheap computers and you knew how much the option, and hence the mortgage, was worth.
Indeed, any loan could be modeled and therefore valued. That meant the loans could be pooled into securities, which would be less risky than what the old-fashioned banker had to deal with. Deaths, divorces, moves all could be estimated from actuarial tables. Meanwhile, the volatility in interest rates would affect the price of the embedded option in the mortgage, and could be modeled.
From that relatively simple model sprang models that predicted the behavior of massive pools of mortgages with the precision of Newtonian physics. By assuming the future would be like the past, lenders could structure loans with the most outlandish terms.
With statistical modeling, no longer was it necessary to collect and verify information about borrowers. Put everybody in the pool and everything would even out, statistically speaking.
"Technological advances have dramatically transformed the provision of financial services in our economy," Fed Chairman Ben Bernanke told Congress in May, 2006. "Notably, increasing sophisticated information technologies enable lenders to collect and process data necessary to value and price risk much more efficiently than in the past."
From that, Wall Street made the leap to taking those loans and structuring them into securities. Since financiers knew, with statistical certainty, how many loans in the pool would default, they sliced the loans into tranches. The least risky slices would get first dibs on the cash flow from the mortgages, followed in succession by tranches getting cash flows from the pool. The last in line would what was left over. In good times, it was a lot; in bad times it was nothing. But like on a chess board, there were pawns arrayed to protect the king.
Just over two years later, Bernanke was singing a different tune.
"Although the severity of the financial stresses became apparent only in August [2007], several longer-term development served as prologue for the recent turmoil…The first of these was the U.S. housing boom, which began in the mid-1990s..A second critical development was an even broader credit boom, in which lenders and investors aggressively sought out new opportunities to take credit risk even as market risk premiums contracted," the Fed Chairman told the International Monetary Conference in June.
Bernanke's faith in the technology to model and price precisely the risks of models upon which billions, even trillions of dollars' worth of opaque derivatives clearly has been shaken, as the Richebacher Letter points out. (The publication carrying on the name of the distinguished late economist of the Austrian school of economics provided those quotes as well.)
Nowhere has the misplaced faith in the pricing of mortgage instruments been disproved so dramatically as in the writedown and disposal of $30 billion face value of collateralized debt obligations by Merrill Lynch for about 22 cents on the dollar. Merrill financed three-quarters of the sale, so it realized roughly a nickel on the dollar for these CDOs, which could be wiped out by another five percentage point drop in their value.
Still, Merrill opted to get what it could for the CDOs now rather than wait for a better price later. Optimists say this sort of throwing-in-the-towel behavior is symptomatic of market bottoms. Pessimists contend other banks also have to bite the bullet.As for America's transformation to a nation of money-changers from manufacturers, consider the state of the U.S. automotive industry. For years, Detroit ran on finance (and was run by financial types rather than car guys.) The financial models showed that auto makers could make more money from the leasing and financing of cars than making them. And while you're at it, why not make mortgage loans as well? Auto loans and leases as well as mortgages could be packaged into asset-backed securities that would be sold into the market. The finance arm, once the handmaiden, nearly superseded the manufacturing center.
Now, what once was called the Big Three, GM, Ford and Chrysler, no longer can offer leases that make sense economically, which will further crimp their bread-and-butter business of selling autos. Now that U.S. automakers finally have models competitive with Japan, Korea and European models, they can't provide the financing.
All of which makes the stabilization of financial markets such a priority for policy makers. The Fed and the Treasury have taken radical steps that trample on free-market principles to maintain the functioning of financial markets in order to stave off a meltdown.
Like it or not, the experience of the past 12 months shows the importance of keeping the markets functioning.
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