Creating Incresed Risk by Trying to Limit Risk

Yes, there are a lot of “greed merchants” on Wall Street, agrees high rolling economic forecaster Ted Forstmann in an interview with CNBC’s Charles Gasparino reported in this WSJ op-ed. But these greed mongers don’t act alone, says Forstmann, who has “been calling them on the carpet for years….”

Gasparino writes, “The greed merchants needed a co-conspirator, Mr. Forstmann argues, and that co-conspirator is and was the United States government.” He quotes Forstmann as saying, “They're always there waiting to hand out free money. They just throw money at the problem every time Wall Street gets in trouble. It starts out when they have a cold and it builds until the risk-taking leads to cancer.”

Right now the Fed and the Treasury are engaging in shockingly unprecedented activities that are presented as necessary “to ameliorate a once-in-a-lifetime financial "perfect storm."” Gasparino argues that the only thing that makes these actions unique is their size. He documents how the federal government has been subsidizing risk for three decades “on the taxpayer dime.”

Pricing down risk
One of the ways the government has done this is through easy money — a policy to which the Fed has repeatedly turned since the 1980s to lessen “the pain of the risk-taking gone awry.” They did this with the junk bond crisis, the 1980s mortgage meltdown, the 1994 Orange County bankruptcy, when LTCM “blew up” in 1998, and again in the current crisis.

This easy money policy “opened the door for increased risk down the line.” The use of this tool, which essentially subsidizes improper risk on the backs of savers, is now so common that its effectiveness is diminishing.

In addition to this, “policy makers transformed home ownership into something that must be earned into something close to a civil right.” They made this work by creating the mortgage bond, “which allowed banks to offload the increasingly risky mortgages to Wall Street, which in turn securitized them into triple-A rated bonds thanks to compliant ratings agencies.” Gasparino asserts:

“This is where the real sin of Fannie Mae and Freddie Mac comes into play. Both were created by Congress to make housing affordable to the middle class. But when they began guaranteeing subprime loans, they actually began pricing out the working class from the market until the banking business responded with ways to make repayment of mortgages allegedly easier through adjustable rates loans that start off with low payments. But these loans, fully sanctioned by the government, were a ticking time bomb, as we're all now so painfully aware.”

The bailout of LTCM in 1998 cemented understanding among investment bankers that the government would step in to stanch the pain anytime big time risk produced big time pain. It just had to appear to be “too big to fail.” This created tremendously perverse incentives for excessive risk taking. Gasparino opines that had LTCM been allowed to fail, the resultant pain would have imposed sufficiently severe costs to prevent the kind of risk taking that led to the recent crisis.

When the picture of the most recent financial market meltdown is considered as part of a collage that includes financial crises throughout the past three decades, there is no question that the big investment firms are as guilty as sin. But they could not have brought the market to its knees on their own. They are like druggies yearning for their next hit. They needed a pusher. And that pusher — the greedy bankers’ willing partner — is our federal government.

In essence, successive financial crises became increasingly severe because the clear message was sent that improper risk would be rewarded. Finally we reached the 2008-9 crisis. The pain has been heavy. But true to its form, government has come to the rescue, ensuring that there will yet be another even more severe bubble in the future.

Why would government do this?
We understand the incentives of the investment bankers. But what incentives does government have to engage in this kind of destructive co-dependency? Campaign contributions, lobbying dollars, and special perks no doubt play a large role here. But that alone is not enough. Among the other factors are the elitist mindset that pervades politics, maintenance of what I will call “the club,” and the rise of the investor class.

Almost all politicians today see their role as saving people from themselves. They play the hero; we play the victim. They see themselves as uniquely qualified to rule. Many of us feed this ideology. Sometimes we are pleased to erect windmills for our elected and appointed Don Quixotes to battle.

Many in the political class also buy into the view of economist John Maynard Keynes, who famously said, “The long run is a misleading guide to current affairs. In the long run we are all dead.” Thus, the compulsion to “do something” right now, regardless of long-term consequences is somehow justified in their minds.

“The club” refers to the society that exists among those involved in high finance. Some of these people are in the private sector. Some are in the public sector. Some move back and forth between these sectors. Even if these people don’t personally know each other, they enjoy a relationship that is akin to that of belonging to an exclusive club. They share a similar view and are quick to come to the aid of another club member, as it were, even if that aid involves taxpayer funds.

Nowadays most Americans have assets tied up in various investment instruments. If the financial market is hurting, so are they. When they feel negative consequences from taking financial risks, many are quick to appeal to government for relief. As mentioned above, government officials sit astride their white stallions ready to play the role of hero and eager to quell earned consequences in apparent righteous indignation.

Please understand that this is not a partisan thing. Both parties have a deep history of turning government into the pusher for the high finance community.

Slow learners
I believe it is abundantly clear that the most important players in this game have not yet learned their lesson. Everyone will be happy as soon as the current pain passes. Government officials, investment bankers, and investors will all breathe a sigh of relief and be happy to have things ‘back to normal.’

But that state will necessarily be temporary. When the bubble that is currently being constructed bursts (as it must), it will be a much larger deal than our recent crisis. Perhaps the pain will be sufficient to teach us that subsidizing risk creates a faux vision of limited risk that ultimately causes more pain that simply accepting the natural workings of the risk mechanism.