The free market is not to blame

Amid the frenzy of blame leveled against the “capitalist system” for the near-collapse of the world’s financial apparatus in 2008, came a sorrowful confession from Josef Ackermann, the chief executive of Deutsche Bank. With much publicity he proclaimed that he no longer believed in the self-healing capacity of the free market system… The former believer had become a non-believer. And the cause of his apostasy? The apparent failure of the free market system to detect and correct the abuses that had given rise to the crisis.

The problem started long ago, in the wake of the Great Depression, when it was determined by the Roosevelt administration that finance should be provided by Government Sponsored Enterprises (GSEs) to less than optimal borrowers, to help finance the acquisition of their homes. Two of these enterprises, whose silly monikers have become immortalized in financial history as Freddy Mac and Fannie Mae, were established with the express purpose of providing socially responsible housing finance.

The system functioned tolerably until, during the course of the Clinton administration, Congress decreed that mortgage bonds should not be refused merely because the prospective borrowers were ‘sub-prime’, a euphemism to describe a borrower who was unable to establish his credit worthiness. The politicians had decreed that housing was a social right. Much of the finance, of course, was to be provided by the Freddie and Fannie combination, which is to say, it was to be guaranteed by the taxpayer.

On a different part of the playing field, Alan Greenspan was at work saving the world from the Armageddon threatened by the onset of the Kondratieff Winter. While still a disciple of Ayn Rand he had let it be known that it was his ambition to become Federal Reserve Chairman during the onset of this cycle…for he would know what to do to forestall or confound the apparent inevitability of the tide. By happenstance, or design, he found himself in this position at precisely the right time. The remedy of the maestro, as he came to be known, was to reduce short-term interest rates to near zero, and to hold them there for much longer than economic prudence would have dictated. He was, it seems, resolved to slay the beast, with what has come to be known as the Greenspan Put.

Wall Street, always determined to turn every apparent adversity to profit, was at work on a scheme that would use the liquidity thus created by Congress and the Greenspan Put, to engineer a new set of derivatives, based upon the sub-prime housing bonds, where the value of the underlying assets would be spun out a hundred fold. These instruments, known as Collateralized Debt Obligations, did, it must be conceded, contain an element of twisted genius.
The idea was, essentially, to encourage the originators of the mortgage bonds to write as many as possible, without apparent discrimination, on the basis that the mortgage originators would not bear the risk, which would be packaged and sold on in the form of CDE’s to unsuspecting investors around the world. Who, after all, would dare to question Wall Street’s integrity, and that of their rating agencies?

The lack of discrimination was there for all to see. Many commentators warned against the excesses of the “housing bubble” and foretold of the inevitability of its collapse. Bonds were being granted with little or no regard to the ability of the mortgagor to make payment. “Teaser rates” of interest were offered to seduce the unsuspecting to assume an obligation which would, within a year or two, morph into an unaffordable burden. There were Negative Amortization bonds, (the so-called Neg. am bonds) where the monthly payments did not even cover the rate of interest, which the mortgagor could survive only if the upward march of housing prices was altogether inevitable. Amid all of this Greenspan insisted that he was unaware of the housing bubble. A financial bubble, he proclaimed, could be detected only with the advantage of hindsight.

In the United States a mortgage bond is a ring-fenced obligation. A defaulting mortgagor loses only the property, but faces no additional financial risk. The remainder of his estate is secure against any further claim by the mortgagee. And so, the many properties that are now “under water”, where, for instance, the property is worth $200,000, but the outstanding bond is $300,000, creating an irresistible impetus for the home owner to “walk away”, represent a massive loss to the financial system. These losses will not soon be resolved as many of the “toxic assets” have been taken as security for the emergency loans advanced to the banking system by the Federal Reserve. Those that remain on the balance sheet of the institutions are not marked to market, according to generally accepted accounting practice, but are given a fictitious valuation, with the approval of Congress, to enhance the status of the balance sheet in what would otherwise be called a fraud.

Who is at fault? We have heard it said that the capitalist system is responsible for the chaos that has been created. That depends upon one’s definition of the capitalist system. Does it include a manipulated money supply and pricing mechanism; essentially under the control of the state? Does it include the decree of Congress on the criteria to be applied by private financial institutions in the determination of a prospective debtor’s credit worthiness? Does it include the “most favoured institution status” accorded by Congress to the big Wall Street banks? Does it include the concept “too big to fail” and the improvident risks that a privilege of that sort will inevitably encourage? If capitalism comprehends all of this, then capitalism is to blame, but then capitalism is not the same as the free market.

Author: Rex van Schalkwyk is a former judge of the Supreme Court of South Africa and author of numerous articles and three books. This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the author’s and are not necessarily shared by the members of the Free Market Foundation.

FMF Feature Article / 20 April 2010

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