The truth behind the market meltdown

As fund managers and other investment industry experts gather in Cayman for the second annual International Funds Conference, scholars from the prestigious Washington think tank, The Cato Institute, took the time to speak with The Journal about the current global financial crisis.

As a backdrop it’s useful to examine the performance of the Dow Jones Industrial Average over the last ten years. On 14 November 2008, the Dow Jones Industrial Average closed at 8497.31. On 13 November 1998, the adjusted (for dividends and split) close was 8919.59. If you are less than impressed with a loss of 422.28 points, or 4.9 per cent over a ten year period then you are not alone. There has been tremendous volatility, but no net capital appreciation in a decade.

Other indexes, such as the NASDAQ, tell a similar story. Capital has been invested but as much value has been destroyed as created. Investors around the world cannot help but feel they have been manipulated and lied to about the benefits of investing their savings in the stock market.

So what does the future hold in store for investors?
“Today, the most urgent task facing President-elect Barack Obama is stabilising financial markets by instituting policies that foster economic growth and prevent the type of boom and bust cycle that has just wiped out a decade’s worth of wealth accumulation,” says Gerald O’Driscoll a senior fellow at the Cato Institute and former President at the Federal Reserve Bank of Dallas.

What makes Obama’s task all the more difficult is a perfect storm of bad policies and practices. Admirable goals of fostering more home ownership went horribly wrong as common sense was trampled in the race toward extreme lending practices. Financial services regulation has failed at its most basic task, protecting the soundness of the system. And a dysfunctional compensation system has given corporate managers incentives to take excessive risks with investors’ money in order to obtain huge bonuses.

Lawrence White, an adjunct scholar at the Cato Institute and Professor of Economic History at the University of Missouri-St. Louis, says, “As policymakers confront the ongoing US financial crisis it is important to take a step back and understand its origins. Those who fault “deregulation,” “unfettered capitalism,” or “greed” would do well to look instead at flawed institutions and misguided policies.”

“The expansion in risky mortgages to underqualified borrowers was encouraged by the federal government. The growth of “creative” nonprime lending followed Congress’s strengthening of the Community Reinvestment Act, the Federal Housing Administration’s loosening of down-payment standards, and the Department of Housing and Urban Development’s pressuring lenders to extend mortgages to borrowers who previously would not have qualified.”

But perhaps the biggest factor in the growth of this bad debt bubble was the cheap money policy of the Federal Reserve. Following the 2001 recession, Federal Reserve chairman Alan Greenspan slashed the federal funds rate from 6.25 to 1.75 percent. It was reduced further in 2002 and 2003, reaching a record low of 1 per cent in mid-2003 where it stayed for a year. The rate remained at 2 per cent or less for three years and for most of this period the real (inflation-adjusted) fed-funds rate was negative. People were being paid to borrow and they responded by often borrowing irresponsibly.

When investors believe government will bail them out, they increase their risk-taking and leverage, just as Bear Stearns and other large investment banks did. And when foreign central banks know that the US Treasury stands behind the debt of government-sponsored mortgage lenders, there will be an artificially large market for their securities. Especially when rating agencies and regulators who were supposed to monitor risk-taking were asleep at the wheel.

When a bank can originate a high-risk loan and then launder it on Wall Street and put it back into the banking system as an AA-rated security that is surely a sign of a failed regulatory system. Most of the true risk is still there, but that risk is now hidden from capital requirements.

Arnold Kling, Adjunct Scholar, Cato Institute, explains, “The bank is able to reduce its capital requirements by exchanging its loans for securities. For bearing the exact same credit risk, Freddie Mac was allowed by its regulator to hold less capital than the bank. With securitization, the credit risk goes to where the capital regulation is softest, a problem known as regulatory arbitrage. If there were no regulatory differential, the bank might keep the loan in order to avoid the unnecessary transaction costs of securitising it.” This phenomenon resulted in Freddie Mac and Fannie Mae growing to own or guarantee about half of the United States’ $12 trillion mortgage market.

A further problem Kling contends is that with rapid financial innovation, firms are able to stay within the letter of the law while at the same time subverting the purposes of regulation and violating their responsibility to maintain safety and soundness. He argues that the innovations in mortgage finance over the past twenty years have gone beyond the ability of industry executives and regulators to understand and manage. Executives were making decisions based on a distorted assessment of the risks involved.

Consider subprime mortgages. In 2001, there was $190 billion worth of subprime loan originations — 8.6 per cent of total mortgage originations. In 2005, there was $625 billion worth of subprime originations – 20 per cent of the total. In the same period, the percentage of subprime mortgages securitised — loans that were packaged and sold to investors — rose from just about 50 per cent to a little more than 81 per cent. (These numbers all trailed off slightly in 2006.) The great easing in monetary policy ended (with a lag) when the Fed began raising rates in June 2004.

The subprime saga follows a familiar pattern. Easy credit begets a boom and then the inevitable tightening of credit bursts the bubble. What is not familiar is the scale of the devastation wrought in this boom-bust cycle.

No president could want these events to repeat themselves on his watch. But they could be repeated.

The economy now confronts deflationary forces. The Fed will likely concentrate on those deflationary forces for too long, if history is any guide, and this will rekindle an asset boom of some kind. The fiscal “stimulus” being contemplated by Congress could be another economic accelerant. If both the fiscal and money stimulus efforts kick in just as market forces also kick in, we’re likely to see another unsustainable boom that will be followed by a bust.

The incoming administration must think about that possibility because the timing of boom and bust cycles seems to be shortening.

One strategy Obama could employ to stop the next asset bubble from being inflated is imposing a commodity standard on the Fed. A commodity standard (such as a gold standard) imposes discipline on a central bank because it forces it to acquire commodity reserves in order to increase the money supply. Today the government can inflate asset bubbles without paying a cost for it because the currency isn’t linked to the price of a commodity.

With a commodity standard in place, the government would also have price signals that would alert it to the formation of a bubble. This is because the price of the commodity would be continuously traded in spot and futures markets. Excessive easing by the Fed would be signaled by rising prices for the commodity. In recent years, Fed officials have claimed that they cannot know when an asset bubble is developing. With a commodity standard in place, it would be clear to anyone watching spot markets whether a bubble is forming. What’s more, if Fed officials ignored price signals, outflows of commodity reserves would force them to act against the bubble.
The point is not to deflate asset bubbles, but to avoid them in the first place.

Scholars from the Cato Institute will be featured speakers and sit on discussion panels at the upcoming International Funds Conference hosted in Cayman January 9, 2009. For more information please call Michelle at 623-6712 or visit



Jerry Taylor, Senior Fellow, Cato Institute, who will be speaking at the International Funds Conference on 9 January on a review of the potential energy policies of the new US President and their possible global economic impact