How Did We Get Here?
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Where are we headed?
If you think there are serious troubles in the financial markets, you are right. We are witnessing cataclysmic changes on Wall Street. Some of the recent Wall Street Journal headlines “Worst Crisis Since’ 30s, With No End Yet in Sight”, and “Mounting Fears Pummel World Markets as Banking Giants Rush to Find Buyers” are not scare tactics aimed at increasing readership. Things really are that bad.
Last month during a television interview Treasury Secretary Henry Paulson looked like a man who had seen a ghost. Here is a 30 year Wall Street veteran, Harvard MBA, and the Treasury Secretary for the largest economy in the world; shaken to the core. In his own words American International Groups (AIG) $85 billion loan with the United State Government taking an 80% equity position is not an option he likes choosing. However, he does not hesitate to add that the alternative choice is actually much worse. My point and the really scary thing is that we are witnessing a meltdown of Wall Street, the way we knew it.
How did we get into this position? I’ve been asking questions, listening, and reading and have concluded that the problem is extremely complex. I’ve also concluded that many of the so called experts, politician, and the presidential candidates do not understand the problem and are struggling to grasp the issues just like you and I.
We all know about the relaxed mortgage underwriting rules resulting in subprime mortgages. If you are like me you might be thinking that there couldn’t possibly be that many bad loans. You are talking about enough “toxic loans” to tank the strongest economy in the world. However, if these “toxic loans” had remained on the books of mortgage lenders then the problem would have been limited to the default of the individual mortgage companies, similar to the S&L crisis of the 1980’s.
The problem did not stay with these mortgage originators. The mortgage originators quickly sold the loans to Fannie Mae and Freddie Mac, which isn’t unusual. The difference is what happened to them next. Freddie and Fannie with the help of investment banks developed a new investment products built around these mortgages.
These securities contained the “toxic mortgages” were then added to other investment products and allowed to spread though out the investment system both nationally and internationally (England has a similar problem with subprime mortgages). To use a medical analogy the cancer cells, metastasized, i.e. spread through out the whole body, in our case these “toxic mortgages” spread through out the financial system. Resulting in a very sick patient or financial system.
Where are We Headed?
The Federal Government is proposing a $700 billion program to help the market. One aspect of this program is for the US taxpayers to help the financial markets by purchasing these tainted investment products, including the “toxic mortgages” at the hold to maturity price; if all of the payments are made on a “toxic mortgage” then a hold to maturity return would be realized, which includes principle and interest the best price. However, currently these tainted securities are valued at fire sale prices, which caused the owners value to be less than the purchase price resulting in write downs; even at these low prices nobody is willing to buy the tainted securities causing a liquidity crisis. The Federal Governments proposal is designed in part to purchase these contaminated products from financial institutions providing badly needed liquidity.
The US taxpayer’s money will be used now to purchase these toxic products with the eventual hope that the market for these products will improve. The best hope is that taxpayers may be able to sell at a profit recouping our investment with interest. There is also the chance that these toxic assets will never have any value or will be sold for pennies on the dollar resulting in a loss of principle, which will result it the actual total cost of the governments program.
In theory this is a workable plan but we need to be concerned the federal government’s unnecessary interference in the operation of private markets. Without proper controls this could turn into the nationalization of our free enterprise financial system pushing us closer to socialism, which has not worked in other countries and will not work here. The Security and Exchange Commission (SEC) is responsible for these controls and up to this point has not done an adequate job. It has been said they do not have the tools to deal with our current issues, which is a valid argument.
The SEC was founded after the market crash of October 1929. The founding goal was to restore confidence in financial markets by providing federal oversight. Our current problem is that we have regulations from the 1930’s that were designed to prevent problems from the 1920’s trying to regulate markets in a new century. The SEC has done a great job of preventing a return to these old problems but is not adequately addressing current issues.
The Federal Deposit Insurance Corporation (FDIC) is a great example. In the 1930’s FDIC insurance was established and set at $100,000 per bank account; this was more than enough needed to cover insurance for individual bank accounts then. However, one dollar in 1925 is now worth $10 . In present dollars the individual FDIC insured account should be up to $1,000,000 not $100,000. This is just to provide the same amount of protection that was originally intended. Currently, only 40% of all deposit accounts are actually covered by FDIC insurance
My point is that we need to move forward with the plan proposed, but we really need to update the oversight process. The SEC needs to be brought into the current century, dealing with our new economic realities not only those from the past. If for example we move from a rules base oversight system to an oversight system grounded in principles, more on this topic in future editions of B/NV, our oversight can adjust to market changes and remain ready to deal with current and future issues.
The bottom line for all entrepreneurs and small business people is that obtaining capital for growth and expansion has dramatically changed. To grow and adequately support our businesses we need to rely on our creativity and resourcefulness to meet future capital needs. One area may be the use of more equity for smaller businesses instead of debt financing. Although, change is frightening it creates incredible opportunities for inventive people to develop new products and markets.
The intent of this article is to provide background to frame topics for upcoming issues. In future issues of Business/News & Views, the Views Section, we’ll take a closer look at problems and possible solutions for real business situations i.e. inventory, credit, debt, and more.
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Library of Congress Cataloging-in-Publication
Business/News & Views® / by David. W. Weatherholt
ISBN: 978-0-9823041-1-2 (electronic format)
Published in the United States of America through www.waconsult.com
Published in an electronic format by Weatherholt & Associates, LLC
First Trade Publishing: October 2008
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