Lessons

Two thoughts on the recent economic crisis triggered by the mortgage meltdown...

First, the Glass-Steagall act worked.  Separation of commercial banking, where most consumers retain their savings, from investment banking may have just saved the economy in 2008.  While investment banks perform a variety of services typically for corporations, including brokerage, lending, and equity underwriting, their failure no longer directly impacts consumers.  At the onset of the Depression, as the major banks (which acted as both commercial and investment banks) failed due to market losses, consumers found themselves without money as their banks closed their doors (and their accounts) to them.  Those that did survive the market crash found themselves in the midst of a run on their capital, until there was no more cash in the vaults to distribute.  There was no money for anyone, businesses or individuals.

With the failure of Bear Stearns, consumer deposits were not at risk.  What could have happened, however, is that Bear went under, and all of its investors and creditors would themselves find themselves struggling: large investment pools that had backed other, riskier assets would have suddenly evaporated, resulting in margin calls on loans or obligations not directly related to Bear.  Businesses relying upon Bear Stearns to raise capital in the markets could no longer have done so.  The ripple effect through the financial system would eventually (indirectly) have affected us all.

But the Glass-Steagall Act confined that damage to Bear Stearns--for now.

Second, listening to Robert Rubin this morning on NPR, I heard the first good lesson that we might draw from the recent crisis and its precipitating causes.  Rubin recalled that one of the other mistakes that eventually led to the Great Depression was the rampant speculation, at all levels of society and by individual consumers and corporate enterprises alike.  That speculation involved making highly-leveraged investments: large investments backed by small amounts of capital and high amounts of debt.  

The theory of leveraged investing is that the investment will return enough capital to the investor that they can pay off the debt.  The problem is, of course, that works fine in orderly and upward-trending markets--but not so much in volatile or down markets.

To reduce future market risk, additional legislation from the era required that all stock investments have at least 50% capital behind it: that is, you could buy $2 of stock at most for every $1 offered as payment.  The balance would be purchased on margin, and represent a debt that could be called at any time by the broker.

We have the same highly-leveraged situation right now: large investments were made in exotic investment products (whose risk calculations are quite difficult), and which were backed not by capital but frequently by mortgage-backed securities.  As sub-prime mortgage market collapsed due to interest rate resets, increasing numbers of such mortgages went into default--which means that the value of the mortgage to the holder decreased.  A mortgage in default no longer represents a steady income stream, nor an asset--or, at least, not an asset as valuable as a mortgage that is not in default.  While mortgages declined in value, the mortgage-backed securities to which they were attached became less valuable, and the ripple began.  Very large, highly-leveraged investments, backed by mortgage-backed security, all began to unravel.

Rubin proposed an interesting solution (or hinted at, at least) in his interview this morning: that more than just simple stocks should have a higher capital requirement for margin investing.  Whether such a change will ever happen, or whether the change will be applied to many classes of investments is far from certain: the market likes to invest as little as possible to receive the largest returns possible.  To require more capital for investments goes against that natural inclination.

Nevertheless, the lessons from our recent crisis are already starting to appear.  And they look a lot like lessons from the last Great Depression.