If you believe that the best way to handle the current economic crisis is hurling gobsmackingly large amounts of money at it, all to be used at the discretion of the Treasury secretary and the chairman of the Federal Reserve, you may well be an idiot. That’s according to a rule of thumb devised by famed investor Warren Buffett.
#ad#Back in July, Brian Carney interviewed Ted Forstmann in the Wall Street Journal. The reason for the interview was that in 1988 Forstmann wrote an uncannily prescient oped for the Journal warning that the junk-bond craze was going to end badly. Well, just a few months ago in July, Forstmann once again took to the pages of the Journal to caution investors that a fiscal conflagration was imminent. “We are in a credit crisis the likes of which I’ve never seen in my lifetime,” Forstmann said. “The credit problems in this country are considerably worse than people have said or know. I didn’t even know subprime mortgages existed and I was worried about the credit crisis.”
Forstmann also helpfully passed on how Buffett broke down the components of the typical boom-to-bust business cycle. “Buffett once told me there are three ‘I’s in every cycle. The ‘innovator,’ that’s the first ‘I.’ After the innovator comes the ‘imitator.’ And after the imitator in the cycle comes the idiot. Which makes way for an innovator again,” he said.
So let’s look at how the current credit crisis has occurred, using Buffett’s rule. Some innovator on Wall Street slices and dices mortgage debt and manages to sell that debt at a handsome profit. Even though that debt consists of a lot of bad paper lumped in with the good, through the magic of derivatives — and other financial products more complicated to understand than programming God’s VCR — they manage to make money off it. Then come the imitators, piling into the market. Only there’s a lot more bad paper to go around than good, so mortgage securities aren’t as valuable as they once were (and they were financially iffy to begin with).
Soon housing prices stagnate – because every idiot knows that’s what happens sooner or later when real-estate prices rise for years on end – which removes the only thing propping up the value of the bad mortgage debt. Credit stops flowing. Mighty investment banks start toppling. (Lehman Brothers had a mere $2.5 billion in bonuses to hand out to their New York staff before they filed Chapter 11.) The coup de grace? Ordinary Americans are being told to cough up somewhere north of $2,300 for every man, woman, and child in the country, or else we’re facing the prospect of $30 trillion in global wealth vanishing overnight. In Buffett’s formulation, if the taxpayer steps in at this crucial point in the cycle — that has to make us the idiots, right?
So what should we do to avert this imminent crisis? Treasury Secretary Henry Paulson estimates bailing out Wall Street will cost some $700 billion, but it might be more – so why don’t we go ahead and hand him a blank check with no strings attached?
To paraphrase Ronald Reagan, the ten scariest words in the English language are “I’m from the Treasury Department and I’m here to help.”
In some respects, calling in a benevolent financial dictator would appear to make things much simpler. Wall Street is a complicated place and math is hard. Paulson and Fed Chairman Ben Bernanke would have you believe that it’s perfectly natural that the solution to a large financial crisis is throwing a large amount of money at the problem. They seem to hope that no one will notice that the problem with the bailout isn’t ironing out some of the fiscal particulars: It’s philosophical.
When government seizes control of a critical industry, that’s, uh, what do you call it? Oh, yes, socialism. “The government is telling us that capital and credit markets cannot, for several reasons, solve the current crisis on their own – only the federal government and its massive taxpayer base have the authority and the resources to solve it,” noted financial columnist James Ledbetter. “That is state socialism: the philosophy preached by the founders of the Second International, by the radical wing of the American labor movement, through the formation of the Soviet Union and its satellites, and now by Henry Paulson.”
#ad#If you watched Paulson and Bernanke’s testimony to the Senate Banking Committee you were unlikely to be convinced of the purity of Paulson’s motivations. “This is all about the American taxpayer,” Paulson insisted. But when asked about what kind of oversight Paulson would have for the bailout plan — which gives the former Goldman Sachs CEO almost limitless resources to throw at his former colleagues and peers on Wall Street — Paulson stammered that there would be oversight and conflict-of-interest rules but couldn’t give any specifics. Never mind that Paulson might want to explain how he might have even helped create the current situation as CEO of Goldman Sachs. Here’s a question that should have been asked of Paulson, notes financial analyst Barry Ritzholtz: “In 2004, your former firm, Goldman Sachs, along with four other brokers, received a waiver of the net capitalization rules, allowing those firms to dramatically exceed the 12-to-1 leverage rules. How much was this waiver responsible for the current situation?”
While that rather pointed question didn’t get asked, the Wall Street Journal tersely noted of Paulson’s testimony regarding the bailout, “Lawmakers appeared unconvinced until the end.” It’s reassuring that Congress seems skeptical now. But where have the skeptics in Congress been? Or the media, for that matter?
Last summer, Chairman Bernanke said that “fundamental factors — including solid growth in incomes and relatively low mortgage rates — should ultimately support the demand for housing, and at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system.” So what changed between then and now? In retrospect, it sure seems obvious that major financial institutions weren’t properly leveraged; and the housing crisis was unfolding for everyone to see.
We’ve heard what Paulson and Bernanke propose to do in as much detail as they appear prepared to provide, given the urgency of the situation. And throwing their hands up and asking for all the money in the world so they can convene some smart people in a room and fix this at some point in the future just isn’t good enough. Turning the U.S. Treasury into a blank check may lift spirits on Wall Street, but it might also defraud and demoralize Main Street. Doling out large sums to prop up Wall Street may end up being inevitable. But before Paulson, Bernanke, and the federal government do anything, a lot more tough questions need to be asked and answered. Demanding anything less might be considered idiotic.
– Mark Hemingway is an NRO staff reporter.