Easy Money

At the core of the financial collapse was the overall notion of “easy money,” lenders willing to lend at low rates combined with borrowers who were encouraged and then addicted to borrowing for just about every purpose. It was this practice combined with unregulated markets and unwatched accounting methods that spawned a “valuation” mythology that justified the debt. Credit rating agencies effectively gave bad debt instruments good ratings. Consumers were told by lenders and realtors alike that the housing market had no place to go but up. And interest rates were staggeringly low compared to the not-so-distant past. Consumers have been slammed with shrinking credit, housing prices have collapsed, and except for mostly-government-subsidized loans, real estate loans are exceptionally hard to get these days.

With new financial regulatory statute pushed by Senators Chris Dodd (D- CT) and Barney Frank (D-Mass.) likely to become law – the death of W. Virginia Senator Robert Byrd (D) may slow that down, however – it is interesting to look at why Wall Street is still addicted to debt, where they can get it, and what impact, if any, the new law might have on stemming that addiction. If you fund business activities with real investment equity – the equivalent of paying cash for what you spend – the cost of capital is significant and has a permanence about it. Investors own a piece of your enterprise, have a continuing right to a share in the profits (without a cap), and they may even get some voting rights along the way.

Debt, on the other hand, is terminated when the note is paid off, the interest (which is tax deductible as well, unlike equity) is a clear calculation with a cap, and when rates are low, they improve the upside – it is the company (and hence the shareholders) who get to keep the increase in value of the company above the cost of the borrowing; the lenders just get their interest. So growing the company with debt is clearly attractive, and if you can borrow lots of money at low rates, the return for the equity shareholders can multiply significantly. The catch? If your company contracts, you can’t pay back your loans, you file for bankruptcy. But since the mantra on the Street is steady growth, and companies are in value competitions (called the stock market) with other companies to determine their worth, if you don’t borrow to grow and your competitors do, their values and returns to shareholders will outperform you by miles… and if you are running company, trust me, you will be replaced by an angry board of directors.

Without valuation and accounting mythology to support these borrowings, however, they simply aren’t possible; solid regulation would, of course, explode the myths. And as Wall Street watched as mythology-directed legislation was proposed, they launched their massive lobbying efforts figuring that average Americans could never understand the complexities involved, and if they could sell “regulation and taxation” as un-American, they could continue slorpping at the lending trough, which may have been cut off for you and me but is still very much alive in the big financial and corporate world.

The July 2^nd theDeal.com explains what happened: “American officials spread the gospel of light regulation and low inflation around the world. ‘We were exporting economists and economics theory. We trained the world’s finance ministers and central bankers, and it turned regulation into a Potemkin village,’ [says William Black, associate professor of economics and law at the University of Missouri-Kansas City, an expert in financial fraud and a former senior deputy chief counsel at the Office of Thrift Supervision.] In Europe, the Zeitgeist was embodied as ‘principles-based regulation,’ a rejection of bright-line rules in favor of loose frameworks governing accounting rules, capital levels and leverage. In the U.S., the philosophy took its form in the shift toward self-regulation. Another result was the adoption of accounting rules that allowed U.S. banks and other financial institutions to carry impaired assets on their books valued above their current trading value. Just as the allowance of off-book activities fueled the Enron and WorldCom scandals, Black says, permitting assets to be overvalued encouraged the subprime mess. The huge profits and bonuses on Wall Street are impossible with prudent lending, which is a low-margin business, he says.”

But we’re still too terrified to force financial companies to report the true value of the collateral for all their loans, allowing many companies to show paper profits, when they have staggering losses instead. What does the new legislation do about this? “Congress dodged the opportunity to mandate write-downs on the hundreds of billions of bad assets on banks' books. ‘Nobody thinks you should have to record losses as a result of some weird panic in the market,’ Black says. ‘But they studiously ignore that the losses weren’t temporary. If this was just a temporary problem due to panic, where is the secondary market in nonprime assets?’ He says, at best, nonprime assets are trading at 50 cents on the dollar, but more likely at 15 cents to 20 cents. ‘If carried on the books at their t rue value, there would be massive losses in the financial industry.’” theDeal.com.

Others fear that if Congress forced this write-down and the required less borrowing and more of down-payment, this would contract the already slender credit markets that have survived. And the rules clearly favor big players with unequal access to “the cheapest money” (loans from the Federal Reserve allotted to banks); this is why Goldman Sachs became a commercial bank – they could borrow really cheap fed funds, but instead of deploying that capital into the commercial markets, they kept (keep) most of it and use it for internal trading and investment purposes. So Congress struck a balance and left some matters unsolved by the new legislation. If we are under the illusion that the new law would create a “never again” scenario that would prevent another similar economic collapse… think again. Mythology continues.

I’m Peter Dekom, and one day America will wake up and realize that slogans born on Wall Street to be swallowed whole by voters are truly what are un-American.