Economy: How Could This Have Happened?

We have literally hundreds of thousand of analysts with various institutions, traders, executives, board members, officials and lawmakers with first rate expertise and countless years' of experience watching financial practices closely. Many of them even comment on the market regularly on CNBC, in The Wall Street Journal, on Bloomberg, in The Financial Times and in media outlets around the world.

Among these experts are two of the most qualified and experienced people in the country – the widely recognized No. 1 scholar on the subject of the Great Depression, Fed Chairman Ben Bernanke, and arguably the most successful Wall Street executive, Treasury Secretary Henry Paulson.

The Questions

So how did we run into an "Economic Pearl Harbor" (as Warren Buffett described it) in September and a 20% drop in market capitalization in October alone? How could this have happened under the watch of so many brilliant minds?

Economists have long argued about the existence of a housing bubble based on the fact that growth in home prices has been outstripping inflation and income for many years. And this was long before subprime became an issue. Home prices have been growing steadily above inflation rates by a wide margin since 1998. We talked about a likely downward adjustment in home prices as early as 2002 and repeated the theme in the following years before an adjustment finally occurred in 2007.

Unfortunately, few economists had reasonable exposure to, or for that matter an understanding of structured financial products. Practices in the MBS/CDOs and CDS areas were (and for many still are) a total mystery. Remember that right before the breakout of the financial turmoil in July 2007, Robert Rubin, then executive Chairman of Citigroup – a major producer of CDOs – openly admitted in a public interview that he was not familiar with CDOs. Well, we are all familiar with them now!

In defense of our collective wisdom, we need to realize that the current situation was not created by a single issue.

In reality, it was created by a confluence of a number of mutually reinforcing trends and policy mistakes. These included:

• loose monetary policy
• the rapid growth of financial leverage
• opaque and technically deficient derivatives and financial products
• flawed credit ratings by rating agencies
• fragmented regulation
• lax diligence
• negligent governance
• fraud
• major oil shocks
• socially engineered housing policy beginning with the Community Reinvestment Act in the late 70's, followed by Fannie and Freddie relaxation of lending criteria from the mid 90's under policy guidance and HUD's no-money-down mortgages in the early 2000's.

This confluence of historical context and level of complexity ultimately led to a governance failure.

More Questions

So, what do we have to do now?

In October, we saw a number of unprecedented policy initiatives globally to stem the deleveraging process and unfreeze global credit markets, including G7 governments’ injection of capital into their banking systems and provision of various guarantees for bank funding. These initiatives seem to have had some positive impact as LIBOR rates have come down noticeably. However, they have not been sufficient to restart global credit markets.

Credit spreads have continued to widen in recent weeks and the overall credit conditions have in fact tightened further based on various surveys. In a recent survey by Reuters, 40% of lenders and loan investors said they didn’t expect the credit climate to improve significantly until 2010, albeit they believe by that time the worst would have passed.

For the financial system to work, capital, liquidity (credit) and trust/confidence together form necessary conditions. The last element – trust/confidence – has been missing for quite a while now. The trust has been damaged by fraudulent practices, poor product and services quality, and the financial system’s lack of transparency in the credit default swap and counter party risk areas.

Policy measures have been aiming at restoring capital and liquidity, with a hope that trust and confidence can just come along. Unfortunately, trust and confidence have a life of their own, which apparently has negatively affected capital and liquidity at this point. So how to deal with the trust and confidence issue is the key to stabilizing the financial market.

The presidential election has magnified negative messages. Fierce criticisms targeted at the current administration, as we witnessed in the past few months, have inevitably weakened the American public’s confidence on policy measures under the current administration. In just a few days, a new president will be elected and one of the uncertainties in the marketplace will be removed.

Let’s hope the new administration will be able to quickly establish leadership through rational persuasion and restore confidence and pride in this country.