Dear Mr President,
It is almost unfair to criticize you given the extraordinary circumstances surrounding this country when you took the oath of office. Time was a precious commodity and you were forced to make urgent decisions. To be clear, I cannot think of anyone else I would rather have at the helm now than you. Choosing generals was job number one and, for the most part, you did a fantastic job.
However, we clearly find ourselves in a severe financial crisis that, due to improper handling and an initial failure to recognize the scope of the problem, has mutated into a full blown economic crisis. Continued failure to right the ship is increasing the chances of a total global economic and social breakdown. In 2007, Bernanke and Paulson’s assurances that the subprime mortgage crisis would be contained only served to illustrate their complete lack of understanding of the circumstances. The crisis was no more about subprime mortgages than an influenza outbreak is about runny noses.
People smarter than me will tell you that a large contributor to economic growth over the last 10 years (some would say 20) was fueled by increasing levels of debt. Debt came to pervade every aspect of developed economies from consumers, to corporations and financial institutions, all the way up to local and federal governments. This debt came in the form of credit cards, auto loans, school loans, residential mortgages, commercial real estate loans, corporate bonds, municipal bonds as well as Treasury bills, notes, and bonds.
Scholars will debate the true causes for decades, but let me offer this as a plausible explanation. Pension funds, endowments, and trusts have financial obligations that are met by targeting a given level of return on investments made over a period of time. When the Federal Reserve, in conjunction with global counterparts, brought interests rates below 4% in 2001, these pension funds, endowments, and trusts found it increasingly difficult to meet their obligations. This forced them to move away from traditional safe investments such as Treasury bonds and into other investments that appeared safe, yet paid higher rates of return. In fact, many investors were restricted to securities that were christened the coveted AAA rating from ratings agencies such as Moodys, S&P, and Fitch.
The investment instrument that many of these funds turned to was something called a collateralized debt obligation (CDO). There are many fantastic explanations of CDOs around the web, e.g. see This American Life for mortgage CDOs. Think of a CDO as a bunch of debt sources (some listed above) whose interest payments are pooled together into a cashflow waterfall. The advantage of having a pool is that it is less susceptible to borrowers not making payments. For example, if you gave one person a loan and you depended on them making their interest payments so that you could pay your own bills, you’d be in trouble if they stopped paying. But if you were receiving interest payments from 1,000 loans, the impact of single borrower stopping payments is less severe.
A CDO goes one step further. A CDO takes this waterfall and redistributes the cashflows in a way very much reminiscent of the champagne tower. As long as some borrowers continue to make interest payments, the top champagne glass is likely to always be full. Ratings agencies then published models that attempted to assess the risk that the top glass may run dry in order to facilitate the design of these pools. The goal was to achieve a AAA rating on that top champagne glass so that the banks could sell them (the cashflows, not the loans) to pension funds, endowments, and trusts that were starving for safe investments that paid more than traditional safe investments rendered unattractive by the Federal Reserve and the Treasury Department.
This was a boon for the ratings agencies because they charge fees to rate securities. If a bank owned a bunch of loans and wanted to get them off their balance sheets to free up capital, they’d structure them into a CDO, plug a few parameters into the ratings model, and essentially pay the ratings agency to christen the top champagne glass AAA. In some cases, the loans in the pool were so risky that even the top champagne glass was not sound enough to warrant a AAA rating. In such cases, the insurance companies were happy to step in, and for a fee, would guarantee that the top glass always remained full.
Now, Mr President, I understand that you are already familiar with CDOs. Nevertheless, I hope this short description was helpful because it sets the stage for what I need to say next. Statements by Bernanke, Paulson, and now Geithner have focused on the mortgage market because that was the first symptom to appear. If the problems were confined to mortgages, Geithner’s plan might have a chance to succeed. Unfortunately, the scope of the problem is more accurately described as a global epidemic infecting all forms of debt. Banks have been pooling together every form of debt imaginable and constructing CDOs from the interest payments. There are CDOs of auto loans. There are CDOs of school loans. There are CDOs of residential mortgages. There are CDOs of commercial real estate loans. There are CDOs of corporates bonds. There are CDOs of municipal bonds. There are even CDOs of other CDOs.
I’m sorry Mr President, but you do not have enough money to back stop all of these legacy assets. Drastic measures are needed and they are needed now. As incomprehensible as it may sound, I believe that you should consider using your Executive power to declare a national emergency. Seize the investment banks and give a blanket guarantee on existing bank deposits to avoid bank runs, while setting rates on new deposits close to zero to avoid draining foreign capital from other struggling countries. Halt the issuance of new CDOs. Impose a temporary 90% tax on all income in excess of $1,000,000.00 to temporarily reduce the need to raise funds from foreign central banks who are dealing with their own problems. Transfer all outstanding credit derivatives to an exchange and enforce punitive taxation on over-the-counter (OTC) derivatives transactions to encourage the swift migration to transparent exchanges, while offering substantive tax incentives for financial institutions who can demonstrate they have completely migrated and no longer participate in the opaque OTC derivatives market.
Your advisors will surely tell you that the OTC market should not be demonized and serves an important role in the market place. I say they are wrong and you should be looking for ideas outside of the establishment. I would be glad to argue my case for any of these proposals on a point by point basis. I would not suggest such radical measures if anyone other than you were in office. Your knowledge and personal conviction in the sanctity of the United States Constitution places you in a unique position to be able to make it work without destroying the foundations of this country.
Many people in the United States are not happy. Some are outraged. Some are confused. Personally, I am outraged by what is going on at the Federal Reserve, The Treasury Department, and on Wall Street and am determined to educate anyone who will listen to me. I hope that includes you. However, the general outrage has not reached critical mass yet. It is not too late to correct course. I am writing these letters because I am still audacious enough to have Hope in your ability to steer this country back to prosperity for all Americans, not just Wall Street cronies living in their echo chambers.
Despite progress you may be making on other fronts, you will ultimately be judged by how well you manage the economic crisis. You’ve chosen your generals and have placed your trust in them. It is time you consider that perhaps you have made a mistake. Geithner and Bernanke are not up to the problems that face them. It is not too late to change course. Listen to Krugman. Listen to Volcker. Listen to Roubini. They are capable and willing to help, but so far you have turned a def ear to them.
The last time public outrage began to overflow was in the 1960’s and 1970’s during the Vietnam War. At that time, many people found their voice in music. I want to leave you by pointing to an example of what makes this country great. Jonathan Mann is an amazingly talented writer and musician who, like me and millions others, have the audacity to continue to have Hope. But, as I said in an earlier letter, the only thing more audacious than the audacity of Hope would be the audacity of squandering that Hope. In this song, Jonathan powerfully communicates the internal struggle many of us feel as we hang on to our remaining strands of Hope:
Prior to the current crisis, economists hailed Alan Greenspan as the “maestro”. Volatility in the markets were at historical lows and monetary policy had conquered the business cycle.
Or so they thought.
What was really going on was the inflation of a global asset bubble. In early 2007, the bubble in housing was obvious enough and the general feeling across the fixed-income spectrum was that things were rich. LBO activity was white hot, which helped fuel valuations in equities. But one person said it plainly and simply. Jeremy Grantham’s April 2007 letter had a deep impact on the way I looked at the world.
It’s Everywhere, In Everything: The First Truly Global Bubble
(Observations following a 6-week Round-the-World Trip)
From Indian antiquities to modern Chinese art; from land in Panama to Mayfair; from forestry, infrastructure, and the junkiest bonds to mundane blue chips; it’s bubble time!
The necessary conditions for a bubble to form are quite simple and number only two. First, the fundamental economic conditions must look at least excellent – and near perfect is better. Second, liquidity must be generous in quantity and price: it must be easy and cheap to leverage. If these two conditions have ever been present without causing a bubble it has escaped our attention. Conversely, only one of the conditions without the other may cause an ordinary bull market but this is often not the case. For example, good or even excellent fundamentals with tightening credit often result in a falling market.
That these two conditions have been met now hardly needs statistical support, so widely accepted have they become. Never before have all emerging countries outperformed the U.S. in GDP growth over a 12-month period until now, and this when the U.S. has been doing well. Not a single country anywhere – emerging or developed – out of 42 listed by The Economist grew its GDP by less than Switzerland’s 2.2%! Amazingly uniform strength, and yet another sign of how globalized and correlated fundamentals have become, as well as the financial markets that reflect them.
Bubbles, of course, are based on human behavior, and the mechanism is surprisingly simple: perfect conditions create very strong “animal spirits,” reflected statistically in a low risk premium. Widely available cheap credit offers investors the opportunity to act on their optimism. Sustained strong fundamentals and sustained easy credit go one better; they allow for continued reinforcement: the more leverage you take, the better you do; the better you do, the more leverage you take.
The combination of the enactment of the Commodity Futures Modernization Act of 2000 with easy monetary policy in the US and Japan created an abundance of liquidity together with an increasing need for “yield” for pension funds and endowments. Institutional investors were increasingly drawn to non-traditional assets after the stellar performance of the Harvard and Yale endowments. At the same time, large financial institutions represented a huge brain drain attracting many of the worlds brightest scientists to the promise of riches on Wall Street. These scientists built hugely complex risk models based heavily on market volatility. During a period of decreasing volatility, these models were signaling “Full Speed Ahead!” The credit derivatives boom was born.
Bubbles are natural phenomena and our ability to control them is limited. One might question whether we should even try. Greenspan (and Bernanke for that matter) was firmly in the camp that believed we should only concern ourselves with asset bubbles to the extent that they directly impact core inflation. When a bubble forms, you let it continue until it bursts and then come in with sweeping monetary easing to help clean up the mess. Upon seeing this happen after the crash of 1987, after the Asian crisis of 1997, and after LTCM in 1998 among others, the pattern had been established. The Greenspan put was born and moral hazard had been introduced to the financial system.
In each case, the overriding fear was a recession. At some point along the way, recessions became sinister. Something to be avoided at all costs. Well, we are now seeing what those costs were.
Recessions are a necessary part of healthy, dynamic, long-term economic growth. By attempting to avoid recessions like the plague, elements of the economy that were ill-equipped for survival were unnaturally placed on life support. If recessions had been allowed to take their course, enough shocks would have occurred along the way that would have knocked down houses of cards long before they grew to become “too big to fail”. The business of insuring pools of bonds could not have grown to behemoth proportions if historically sensible rates of defaults had occurred. Mortgage originators would not have been able to offload loans into these pools so profitably if they were paying historically sensible risk premiums.
It all comes down to a common mistake we’ve made and continue to make since Greenspan took over at the Fed in 1987. Trying to avoid recession at all costs.
When you embrace recessions, you can deal with them. You can try to soften the blow to the unemployed and help prepare them for newer and economically healthier opportunities. The alternative is to keep people unnaturally employed in economically inefficient roles. The various impacts of recessions are fairly foreseeable and hence plans can be made to deal with them.
After repeatedly making the same policy mistakes year after year, here we are again putting elements of the economy on life support that should be put out of their misery. Of course those who work in financial institutions will try to tell you that the entire economy will come crumbling down if you let a large bank or insurance company fail. It is time to call their bluff. These institutions are simply doing what they have always done. They are doing what they are good at. They are doing what they should be doing. Making money. I don’t blame them for benefiting from bailout funds in multiple convoluted ways. It is ingenious. The people I am disappointed in are those who fell for the joke: Bernanke, Geithner and ultimately Obama.
It is time we see through the charade. The financial system will not collapse on itself if we let large institutions fail. On the contrary, the likelihood of a systemic collapse is higher if we do not allow them to fail. Let entrepreneurs step in. There is a lot of money to be made lending to corporations and consumers alike if you have capital and people do have capital. By artificially propping up banks, the playing field is not level. Small banks cannot compete with large banks. It is a perverse path we are on and I hope that if enough people voice their opinion, those in power will see the light.
You cannot stop the pain. Poor policies of the last 20 years have put us in a position where no matter what we do now, there is going to be severe pain felt by everyone. Lives will be forever changed. Businesses will fall into bankruptcy. Overextended derivatives insurers will burn. Overextended consumers will lose their homes and cars. It is inevitable and the more we try to stop it, the worse it will be in the end. Instead, we should embrace it. Like battling a flaming inferno. Sometimes you need to tactically burn down strategic areas to stop the destruction. We need to recognize that we have failed. Get over it and stop trying to prevent the inevitable. Let’s let natural selection work its course so that we can evolve into something healthier and more be able to survive the new ecosystem we find ourselves in.