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Could This Credit Crunch Have Been Avoided?


Unless the present credit crisis actually brings down the global financial system this cycle will happen again...

One recurring rhythm of economies is that when times are good, banks relax lending standards, which leads to bad loans, which in turn leads to bad times. It's happening right now, even though, remarkably, the last painful lesson came just seven years ago with the tech bust. Generational forgetting apparently happens much quicker in the markets than in the real world. Perhaps that is because in the markets there is an accelerant in the form of money -- specifically bonuses – to be made in bubbles. Still, the question lingers: why don't we ever learn?

The simple answer is that we don't learn because we can't. More specifically, a structured finance manager who hit the brakes because he realized that calamity lay ahead would have been fired for underperforming, or not being with the program (as happened to Merrill's (MER) structured products bigwig, Jeff Kronthal, who warned of excesses in the MBS market), or he would find that his team had defected to other shops that were still happily running towards the cliff. Indeed, if the Ghost of Market's Future visited bank CEOs in 2005 and showed them what would happen in the fall of 2007, their first question would be, "Who else knows this?" Isn't this what Charles Prince admitted when he remarked that "as long as the music keeps playing, we'll keep dancing?"

Here's a hot tip. Unless the present credit crisis actually brings down the global financial system (and we're by no means out of the woods), this cycle will happen again. Yes, if we dodge this bullet, we're likely to see the usual barn-door closing in the form of new regulations, etc., but as soon as things stabilize, bankers will abandon their pose as socialists demanding bailouts, and dust off their capes as buccaneer libertarians while decrying the suffocating regulations that impede "the normal working of the markets." They'll buy the votes in Congress to get what they want, and find a new asset class to gallop towards the next cliff (not really caring whether they go over because it's not their money). This cycle can be broken, but to do so requires a profound shift in Americans' thinking about the role of government.

Here's why.

The present mess grew mammoth in large part because banks were able to camouflage problems. Even as the credit bubble was in its early stages, a chorus of commentators began pointing out problems in subprime lending, looming resets in ARM mortgages, the scary leverage in CDOs, and the potential conflict of interest in the rating agencies. Despite this, banks and other financial institutions successfully hid or ignored these problems until this year. When some savvy investors began balking at buying the arcane and opaque instruments that financed the MBS market, the securitizers tried to fob them off on the Asians. When they too balked, the banks held the senior stuff themselves.

This is a little like financing a new wing on your house by pawning your children's organs and blood. It's typical for securitizers to hold the most vulnerable equity tranches of the derivatives they package, but it is unusual for banks to keep tens of billions of dollars in the most senior AAA tranches. Why would they do this? Is it possible that they did it because the fees generated from securitizing fed near term profits and bonuses, while future write-downs would be somebody else's problem?

Barry Ritholtz and other pundits have wondered what the markets would have looked like had the banks actually behaved responsibly and not booked tens of billions in profits that they are now writing down. Since the financials account for some 40% of S&P 500 earnings, it's safe to say that markets wouldn't have broken new records in the last couple of years without the performance enhancing effects of these phantom earnings. With vastly fewer structured products available to finance mortgage lending, it's also safe to say that we wouldn't have seen the housing bubble – or the housing bust.

When everybody has an incentive to cheat, the vaunted discipline of the marketplace goes AWOL (and "everybody" includes investors because they too have incentives to swing for the fences). Admittedly, in an absolute sense this is self-correcting without government intervention. For instance, if people lose confidence in prices and the guarantees of rating agencies, they will withhold their money (what they have left anyway) until trust is restored. Trouble is, the economy will likely grind to a halt while this is happening. So we have a choice: either we can grit our teeth and trust the market to sort this out, or we can grit our teeth and accept a greater government role in setting accounting standards and regulations – not because government knows better than markets, but because only regulation can force institutions to do things that they know that they should do, but lack the courage to do unless everyone else has to play by the same rules.

We'll see what happens, but the pendulum shift towards a new appreciation of the role of government seems to be happening already. Chances are, it will overshoot, just as our infatuation with the godlike power of markets overshot during the past 20 years.

In the meantime, we can guess what asset class will fuel the next bubble should we not break this cycle. As one former Goldman (GS) securities packager put it, "Wall Street's genius is taking simple, transparent and liquid tradable instruments and turning them into opaque and illiquid derivatives, while making money by overpricing the embedded options." That's not going to change, so take your best shot at guessing where the next bubble will pop up. There's only one condition in this contest: The underlying assets will have to be big enough to support several trillion dollars in derivatives.
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