Wall Street's recent collapse has left many wondering where their money will be safe. Trust has been shattered in the stock market and financial institutions. Most of us, who only know of the stock market crash of 1929 from history books, will tell our children and grandchildren that we survived the “crash of 2008.” How could this happen again, and how did we arrive at our current state of financial affairs?
Credit Party Hangover
Wrong-headed government policies motivated lenders to give mortgages to anyone who dreamed of home ownership, regardless of their ability to repay. Lenders were happy to originate these loans because they created an immediate source of revenue while distributing much of the long-term risk to others in the form of collateralized debt obligations (CDO). A “play today, pay tomorrow” attitude permitted many individuals—and the nation as a whole—to live beyond their means. Warning signs of problems in the mortgage sector began more than two years ago when an increasing number of borrowers started to default on their mortgages. The credit crisis took hold when these widespread defaults caused undercapitalized banks to cut back on credit to other potential borrowers.
Congress recently stepped in to pass the Emergency Economic Stabilization Act of 2008 (EESA), more commonly called the “bailout bill,” which allots $700 billion to buy troubled assets, recapitalize banks, and jump-start our financial system again. But will it help? is it enough?
Broken Trust
Let's try this analogy: If we break a bone, we can treat the symptoms (i.e. alleviate the pain), but we must also address the cause of those symptoms (i.e. re-set the bone). Undercapitalization of our financial institutions is merely a symptom of this crisis, and injecting additional capital into them is one way to treat the symptom. The root cause of this crisis, however, is a failure of leadership and a loss of investor confidence. Unfortunately, the solution will not be as simple as fixing a broken bone. Consider how the following events have damaged individual investors' trust in the financial markets.
Stock markets
On Thursday, October 9, 2008, at about 3 p.m., a breaking news report announced that Standard & Poor's had put General Motors on “watch negative.” The reporter explained that the credit crunch might be the final nail in GM's coffin because of liquidity problems. Yet GM's stock price had been in freefall all day, even before the announcement. Was it just a coincidence, or did some traders have access to information that the average investor didn't?
Economic analysis
Major corporate scandals and record numbers of financial restatements have left investors wondering how much credence they should give to companies' financial statements. Credit rating agencies are also of little help, as they failed to identify the latest problem companies in their ratings.
Regulatory oversight
After the Federal Reserve announced that taxpayers would provide $85 billion to prevent the company's demise, officials at American Insurance Group, Inc. (AIG), treated themselves to a retreat costing $400,000. It's no wonder that public confidence is essentially nonexistent in regulators' ability to prevent corruption, waste, and abuse of our hardearned money.
Government officials
Our country's political leadership has shown the American public and the world that the U.S. government isn't working—its inept response to Hurricane Katrina, the escalating national debt, and the lack of a national energy policy confirm that our leaders aren't representing taxpayer interests very well. The pettiness of our elected officials was painfully apparent when the first version of the bailout bill came before the House of Representatives and failed, at least in part because of partisan bickering.
Perhaps our government officials believed they had to do something, but the EESA is a flawed solution that fails to hold accountable those responsible for getting us into this mess. In fact, what's to stop the culprits from doing it again?
In the continuing saga of this episode in our financial history, government actions may serve to stem the panic in the financial markets for now, but unless trust is restored, investors may find that the only way to get a good night's sleep is to hide their money under their mattresses.
As always, I welcome your comments.