Tipping Points

When worlds collide and markets fall, there are always “tipping points,” forks in the road when a wrong decision takes you down the wrong road. Some believe it started in 1978 with Jimmy Carter’s Community Reinvestment Act aimed in part at making housing more affordable to lower income buyers… Fannie Mae and Freddie Mac followed, implemented this philosophy and were spun off as private institutions by the government. Maybe, but the more direct causes, in my opinion, occurred later. Here’s my list; what’s yours?

1999 – Congress partially repealed the Glass-Steagall Act (a 1933 statute that created the Federal Deposit Insurance Corporation {FDIC} and created clear restrictions on where and how banks could operate). In effect, this partial repeal enabled investment banks and stock brokers to merge or be created and operated by commercial banks (and vice versa). The problem? Now investment banks and traders had the ability to borrow money from the Federal Reserve at the discount rate – cheap borrowed money was placed into the hands of folks who loved to invest and play in the markets.

2004 – On April 28, the U.S. Securities and Exchange Commission exempted the largest financial institutions (only those worth more than $5 billion) from the 12 to 1 ceiling on the ratio of debt to equity. This allowed big bad financial players, like Bear Stearns and Lehman Brothers, to leverage themselves (borrow with little “down”), some going up to 32 or 33 to 1! Imagine if we did like that. This enabled these players to demand and absorb the high-yield flimsy derivatives (subprime mortgage-backed securities, credit default swaps, etc.) that only work in markets with stellar growth and cheap money. This demand allowed (actually encouraged) local banks and thrifts to lower their lending standards to satisfy the new demand for mortgage paper, almost at any price.

2004-2006 – As home prices skyrocketed (because of all the new buyers flooding the market after loan qualifications were lowered), as “teaser” rate interest loans were made with deferred interest (to future years), 2006 was the banner year for real estate. Without meaningful SEC oversight, companies that rated creditworthiness (and everyone relies on those ratings) had given subprime mortgage packages very high ratings (meaning they were considered low risk), fueling the buying frenzy.

2007 – As teaser rates began to become very large interest payments (normal interest + risk premium + deferred interest), the rising mortgage default rates told us all the subprime mortgage structures were headed for trouble. And there were $52 trillion dollars of “default insurance” paper (credit default swaps) – issued by big financial institutions and hedge funds – that weren't looking so good. Think of an insurance company that is so certain there will be no claims that it doesn't even have a claims office.

2008 (Summer) – The government realized that it was going to have to intervene as big players, with the potential for major negative ripple effects all over the economy, were about to die. Bear Stearns was forced to merge into another big financial structure. Insurance giant, American International Group (AIG), which covered so much of American risk, got a direct infusion of money from the government in exchange for significant ownership and restrictions. The markets knew we were headed down, but most CEOs thought the government was on the right track; there was no crash and no panic.

2008 (September) – As Lehman Bros. neared bankruptcy, the markets expected the government to force a merger or infuse some working capital to ease the pressure from the toxic derivatives that plagued Lehman’s balance sheet. After all, if Lehman went down, then everyone could go down… and the government wouldn't allow that. Henry Paulson, who has been trying to defend why he bailed out Bear and AIG and not Lehman ever since, let Lehman go belly-up. The markets, all of them, crashed.

2008 (October) – Congress needed an answer quickly; constituents were screaming. The President looked to Treasury Secretary Henry Paulson for a plan, and Henry had one – but it had been created before the big crash. Since this was the only plan that had been fleshed out, it was presented to Congress. Some Republicans wanted top down assistance (the likely effect of the Paulson plan – which originally gave Henry almost unlimited power); many balked at bailing anybody out. They were joined in that sentiment by “Blue Dog” Democrats who didn't want to bail out big financial institutions. The result: the $700 bailout plan that now contained some tax incentives, oversight and other compromises that got enough Democrats on board to pass. Too little, too late, but it was all we got.

Postscript – Paulson’s implementation (top level cash infusion with the hope of a “trickle down”), with a rate cut and buying of commercial paper by the Fed, has only allowed the biggest financial players to hoard cash to cover possible calls on credit default swaps and other liabilities or to merge competitors and consolidate the financial industry. The money has not trickled down to those who need it most. No help for homeowners. No help for small business. Payrolls are failing. Layoffs are everywhere. Paulson himself says it will take months for his package to reach the consumers and stabilize the market. Somebody make the bad man stop!

I’m Peter Dekom, and I approve this message.