Tuesday, September 30, 2008

The Root Cause of America's Financial Problems...and a Good Solution

It all started with the people who wanted to buy something they couldn't afford. Rather than save up until they could, they applied for a loan: for example, for a new car, a home, real estate investment, new furniture, jewelry, vacation, etc.

In earlier times, if their income suggested they would be unlikely to afford to pay back the loan, lenders would turn them down and the person would have been forced to save some money or increase their income before trying again to get a loan.

But in recent years, lenders had a lot of money to lend and had methods--often deceptive methods--of making a profit even if the loan went unpaid, so lenders offered to lend money to unqualified borrowers.

And those borrowers accepted the loans, many knowing they were unlikely to afford to pay it all back but could later walk away from their car or credit card debt, or sell their real estate at a profit if the market went up or walk away from their mortgage if the market went down. And so now, for example, a record number of U.S. homes are in foreclosure. The number of repossessed cars has increased 10% last year and expected to rise an additional 7-10% this year.

In short, the root cause of the problem is borrowers' and lenders' poor ethics.

If poor ethics is the core cause of America's financial mess, then, even if the taxpayer ended up repaid, is the wisest solution to bail out the miscreants with $700 billion ($6,200 from every household in the U.S.) of your and my money? Especially a bailout that even its advocates are unsure how helpful it will be to us on Main Street or even to Wall Street?

(Update: The $700 billion has now been additionally larded with $150 billion in pork. Even in crisis, politicians will be politicians.)

Is the solution yet more government intervention, thereby shackling the invisible wise hand of the free market? Remember the government's track record. Here are a few examples in the financial arena:
  • Fannie Mae and Freddie Mac, massive government-sponsored enterprises, now in financial disarray and under conservatorship. Fannie's stock price has crashed from 70 a year ago to 1.5 today. Freddie's has plummeted from 62 to 1.7.
  • The Community Reinvestment Act, which encourages lending to underqualified borrowers in the name of "social justice" and thus helped cause America's current financial disaster.
  • The Sarbanes-Oxley Act, which mandated that U.S. companies submit mountains of paperwork that cost companies and in turn consumers $1.4 trillion(!) without clear evidence of SOX providing even a small fraction of that amount in societal benefit. You can't legislate integrity; unethical people will always find a way to be dishonest.
Yes, a modest increase in regulation is probably prudent, for example:
  • Requiring buyers of CDOs, CMOs,and CDSs to meet margin requirements, just as stock buyers are.
  • Preventing conflicts of interest between credit rating agencies and issuers of CDOs, CMOs, and CDSs.
  • Ensuring that the companies that write insurance on those securities keep enough capital on hand to make good on the policies they issue.
But in my judgment, a taxpayer-paid bailout and a major increase in government regulation are not the answers to America's financial crisis.

If we are to get to the root cause of our financial crisis and of many other structural problems in the U.S. economy, a far wiser solution is to make the citizenry more ethical.

Of course, that's no easy task. After all, every business major must take an ethics course and that has hardly solved the problem. But I'd certainly rather see the nation invest $700 billion on improving people's ethics than to bail out the bad guys and then try to police everyone from being unethical again. That's not much more likely to succeed than Prohibition was to eliminate drinking.

How would I invest $700 billion to improve Americans' ethics?

1. Parenting education in the public and private high schools, colleges, adult schools, churches, etc., including how to--from Day One--ensure that your child treats ethics as the highest priority.

2. A critical-incident-based ethics curriculum from preschool through college. Many educators will claim that the school day is already overpacked but I believe the time would be better spent on ethics than, for example, on P.E., history, art, and yes, even the currently sacrosanct multicultural education.

3. A public education campaign, much like that used to reduce cigarette smoking, to emphasize the primacy of ethics to the life well-led and an America worth living in.

4. Periodic ethics training in the workplace. Just as annual sexual harassment workshops are required, annual ethics workshops should be. This training should focus on ethical stress points in that particular workplace: for example, whether a salesperson should voluntarily disclose a product’s weaknesses to potential customers.

5. 1-800-ETHICAL. Just as participants in Alcoholics Anonymous can call for counsel and support when tempted to take a drink, a government-paid-for hotline should be available for people, especially in the workplace, tempted to do something unethical.

6. Reinventing our system of electing leaders. Currently, it is rife with opportunity for dishonesty. We get the message that ethics is not primary in America when we see that our leaders get elected by accepting cash from special-interest donors, money that is used to air deceptive commercials and to hire spinmeisters.

7. Enforce our laws. For example, if we allow 13,000,000 people to illegally step ahead of the legal immigration line, and if we bail out unethical lenders and packagers instead of punishing them, we are taught, by example, that ethics is not primary in the U.S.

Of course, forgoing the bailout will mean a serious decline in our economy, but that decline is likely to be shorter and the eventual recovery more enduring than one that would follow a bailout.

As corporate America, government, indeed all of us should have done in the past, we need to eschew short-term profit for long-term, sturdy growth.

Your thoughts?


Anonymous said...

Not just mortgages but car loans and credit card debt are now packaged as bond-rated investments.

Poor ethics packages such into 'bonds' and poor business sense buys it. Once I learned that credit card debt was included in 'bonds,' I realized why bankruptcy law had been so tightened up - it was not because credit issuers couldn't figure out how to stop issuing cards to bad risks. It was because credit issuers wanted badly to sell that debt on at a profit to people who'd massage it, but who needed a better lock on consumers.

The poor business sense, sadly, is backed by law - once something has become a bond, it's return rate is guaranteed unless there is a bankruptcy to reset the rate, or the vast majority (>85%) of the bondholders agree to a reduction.

We can implement an ethics curriculum and my thinking (trickle-up economics; a rebuilding of our infrastructure which is long overdue and which can this time through put emphasis on energy conservation and non-carbon-emitting energy.)

We can fix the economic meltdown not by giving money away but by changing our bankruptcy laws to permit bond repayment rates to reset. Thus, instead of forcing onerous debt collection at the retail level, and bank collapses at the wholesale level as consumers fold up, the pain of the mortgage backed securities (sic) degradation is spread across all of those who invested in them, not just the unlucky few.

And we don't buy a dead-cat bounce on wall street at a cost of 700 B. We might even avoid giving away more banks at a steep discount, as we did last week with Washington Mutual. (Estimated liabilities: 30B. Estimated assets: 290B. Net assets: 260 B, give or take. Kleptocrat discount to Morgan: 2 B. Now *that* is a deal.)

You might find it worth taking a read through

www.creditslips.org for their take on why the current approach is doomed and why black-letter bond law pretty much requires that bankruptcy law be the focus.

Honest admission: although it's my impression that the bankruptcy law we'd be talking about would be corporate bankruptcy law (the sellers of the, ahem, bonds) rather than individual bankruptcy law, I might be wrong.

Grace said...

For some general education on why credit lenders are not our friends, watch the documentary "Maxed Out".
We have all become too comfortable with the quick fix with disasterous results.

Anonymous said...

No amount of ethics courses will work IMO if:

(1) the incentives are wrong (e.g. the govt will
bail you out no matter how poor your judgments or money
is made to be artificially cheap) and

2) people don't understand basic economics.

We are now paying the price because of (1) and (2).

The fact that the Senate just added $150 billion in pork barrel to the initial
$700 billion is unconscionable, IMO.

The financial crisis was caused primarily (not entirely) by government control:

(1) "too cheap money"

The heart of the crisis is the bad mortgage loans in the United States and this was made possible by government. In the United States the Federal Reserve (a governmental body) controls the interest rates for loans through setting the "cost of money" through the federal funds rate. This rate was set below 2% for three years (Nov 2001 to Nov 2004) the longest time in modern U.S. history - and thereafter it remained at historic lows until recently. (http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html). This made loans artificially cheap.

If the market had set the rates, they would have been much more expensive to get and fewer bad loans would have been made because fewer people would have qualified for a loan.

Government price fixing never works in other sectors of the economy [e.g. prices for cars or computers] and for the very same reasons it doesn't work in fixing the price of money. The best government bureaucrats in the world are not smarter than the market - as the former Soviet Union found out very painfully. Anything that is made to look "free" or nearly so will be abused. If we had "free" cars they would be left at the side of the road.

(2) Freddie Mac and Fanny Mae were created by government with the mandate to encourage as much home ownership as possible. They were understood, as GSEs (Government Sponsored Enterprises) [http://en.wikipedia.org/wiki/Freddie_mac] to have the backing of the federal government which made it possible for them to buy riskier loans than would a strictly private enterprise with no federal backing. In fact, this is exactly what occurred and the fed government took them over completely a couple of weeks ago. If you tell people the government will come and save you, they are not going to act responsibly. That is human nature. These two government created entities were basically flawed from day one. It was just a matter of time until they blew up.

(3) The CRA ] started under the Carter administration. It was strengthened under Clinton and Bush tried to rein it in[http://en.wikipedia.org/wiki/Community_Reinvestment_Act.

It was a perfect storm of 1, 2 and 3 which caused the financial crisis we are now facing. The least of the factors was CRA but it contributed to the debacle. All three factors are under government control. When changes were tried by the Bush administration going back to 2003 [new fed agency] they were blocked pretty consistently by the Dems with the class warfare tactic they use so often whenever they can. No one party is entirely to blame, but when it came to reforming the system, the Bush administration tried harder than any other previous administration and the votes were pretty much along party lines which prevented meaningful reform until it was too late.

If more information is needed on which party is to blame for this huge financial meltdown you can hear the Dems and Repubs. in their own voices at a 2004 House Committee Hearing on Freddie Mac and Fannie Mae at:


and then you can draw your own conclusions.

Marty Nemko said...

Thank you, Anonymous, for the very substantive post.

I watched the video you mentioned, and it is sickening.

Anonymous said...

This article brought back memories of learning ethics in Catholic school.

"Right is right even if no one is doing it and wrong is wrong even if everyone is doing it".

It's easy to blame and point fingers at why our economy is bad but a lack of ethics contributed to it.

People at the helm are crooks and no one called them on it. Not our Government officials or people within the companies.

I grew up in a different era and people think my honesty is more odd then refreshing. I have a moral standards that I try hard to live up to. I try and do the right thing even when no one is looking and raised my children that way.

I watch my children in their early 20's working hard, living on their own and going to college. Most of their friends still live at home and their parents still pay the bills. I'm proud of my children.

Some were never taught how to live in the world. That you need to save for a home and family. That new cars are not a good investment. To shop around for the best price. To keep a couple months rent in savings in case you have a lay off or car repair.

This too I must earn...How many times did I hear my Father say that?

My parents taught me the meaning of a dollar. To save for the hard times. To live on a budget. I taught my teenagers the same thing. My parents were my best teachers on learning to live according to ones means.

It would be nice to see public schools bring back ethics to the classrooms. My kids went to parochial school as I did and had to take it.

It's a very good idea for young people to learn a little about integrity. It's a quality that money can't buy...

Marty Nemko said...

I love the most recent comment and think that if we focused on creating people like your children, the world's problems would be largely solved.

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