7 Fixes for a Market Failure

The financial system is substantially frozen.

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Only when the tide goes out do we find out who has been swimming without a bathing suit. The turmoil in the financial world reveals that almost everybody has been skinny-dipping. Even the greatest names have been exposed to humiliation—and a number of them have made an ignominious exit.

I have written about this financial crisis—using the word advisedly—often in the past months because it is so serious and misunderstood. Even now, when we haven't touched bottom, we hear that "the market" will solve all—meaning that tougher regulation by the government should be rejected. But the market won't and can't solve this problem on its own. To appreciate just why, and what must be done, we have to re-enter the casino and see what the key players have been doing with the money.

A casino, yes, because they've been gambling—but gambling with borrowed money. The financial world came to believe that cheap short-term money would always be available, so players could borrow short and make huge profits by buying higher-yielding long-term securities. One trouble was that almost no one understood just what assets anchored these long-term securities. Long-term mortgages sold as "securitized" bundles represented anything but security. They represented unknown degrees of risk between sound borrowers and unsound borrowers. Many of these bundles were ranked by rating agencies with an AAA imprimatur, which in turn attracted major investors from around the world. They all under-priced the risk. The shattering of the illusion that house prices would always rise burst that balloon.

Euphoria of leverage. How could it be that very sophisticated, clever people in finance should be so dumb? The answer is that they were caught in the euphoria of leverage. They borrowed more and more relative to the amount of equity. This was fine when values increased. Earnings boomed. The financial system became a great game of fees and speculation. The total assets of the 10 top banks in the United States and Europe nearly doubled from mid-2004 to mid-2007, mainly through leverage, at a time when the banks' capital to meet their obligations increased by only 20 percent. In 2007, 40 percent of all of America's corporate profits went to the financial services industries, whose debt, as a percentage of the nonfinancial sector, had quintupled in the last 25 years.

Just a year ago, markets were euphoric. But the lending bubbles inflated to such proportions that they burst, causing a disaster in the credit markets and revealing astonishing amounts of credit extended to even the weakest borrowers. As former Deputy Treasury Secretary Roger Altman pointed out, "Historically, C-rated borrowers have been unable to borrow much from public debt markets because over decades more than 30 percent of such low-rated debt defaulted before maturity. In 2006, more than $25 billion of these securities were sold; the previous 10 years, the average was $2 billion." Simultaneously, the bubble in home prices burst.

The decline in values meant the leverage became a noose. Lenders worried about shrinking equity pressed borrowers to sell assets, placing further downward pressure on prices—the beginnings of a vicious circle. If a firm's portfolio is leveraged 33 to 1, it takes a drop of a mere 3 percent to wipe out its entire capital.

The result was credit defaults that hit lenders all around the world. By the time they turned off the spigot, it was, as always, too late. Hundreds of billions of dollars in credit losses have been realized; the International Monetary Fund estimates losses will approach $1 trillion. The Fed has been pouring emergency liquidity into the financial system to avert a collapse.

Much of the credit was extended to finance complex asset portfolios held in a vast array of financial vehicles in a so-called shadow banking system of structured investment vehicles and conduits. Many of these were unregulated, trading in markets beyond the reach of effective oversight and supervision. This meant the firms could take on all the risks they wanted without the government saying boo, as it would have had to do with banks. The shadow banking system depended on unknown trillions of derivatives and other highly engineered financial securities. The volume of derivatives increased globally to $500 trillion by 2008. Warren Buffett described these derivatives as "weapons of mass financial destruction."