When a young Jack Nicklaus won the 1965 Master's, golf legend Bobby Jones said he "was playing a game with which I am not familiar." I have the same feeling about the financial markets today.
This is not capitalism as I learned it. Rather, for the past three decades financial engineers have been playing a game with unlimited upside reward and, thanks to the Federal Reserve and the White House, limited downside risk. The perfectly predictable result: Wall Street has been willing to peddle increasingly dicey paper in return for staggeringly high returns. The phenomenon has been around long enough to have a name: moral hazard.
Just since the 1970s, we have gone though Michael Milken's junk bonds, the savings and loan crash, leveraged buy-outs, Long-Term Capital Management and the hedge funds, the venture firms and the dot.com bubble, the private equity craze, and the subprime mortgage mess. It is all a variation on the same theme. Smart guys take other people's money, leverage it by as much as they can get away with, buy stuff, securitize it, and then flip the paper for a huge profit.
Unfortunately, the deals get riskier and riskier and finally blow up. Then, as evidence of another financial rule—the greater fool theory—someone gets caught holding the bag. And that is where moral hazard happens. If that someone is big enough, say, a bank, the Fed steps in to bail them out. Or even more troubling, the Fed continues to pump liquidity through the whole financial system to keep things afloat. So, to ease the consequences of the bursting dot.com bubble, the Fed made plenty of money available for the mortgage market. That not only kept home prices up, it set off a housing boom, no doc and no downpayment mortgages, and finally, kersplat, here we all are.
A handful of observers, such as the late Fed governor Ned Gramlich, warned of the dangers of subprime lending. Sadly, they were largely ignored in the euphoria.
The latest episode came last Sunday, when the Fed agreed to rescue Bear Stearns and make $200 billion available to keep other brokerage firms afloat. Not commercial banks, mind you, but investment banks and, in the end, their unregulated, off-the-books subsidiaries that are choking on junk-laden portfolios.
Defenders of the Fed's move say Bear Stearns stockholders have paid a huge price, with its shares plunging from $172 a year ago to $5 today. That is true, but the moral hazard here is not so much with Bear, but with those other firms (whose names the Fed will not disclose) who are also being bailed out, thanks to that $200 billion credit line.
Starting in the ‘90s, the Japanese suffered through a decade-long recession because they were unwilling to force financial institutions to write off their bad debts and accept the ugly consequences so they could clear their books and begin lending again. The government let them buy time while, like Dickens' Mr. Macawber, they waited for something to turn up. It is an experience we dare not repeat.
