Fires start when an ignition source sets off combustible material. Runaway fires occur when that combustible material is linked to vulnerable structures. With all of its interconnected wooden buildings, Chicago was a tinderbox waiting for a spark. As the legend has it, Mrs. O'Leary's cow knocked over a lantern in October, 1871, and set off North America's most famously destructive fire.
The combustible material that has fuelled the great market conflagration of 2008 was the hundreds of billions of dollars in mortgages written to Americans who had neither savings nor a record of steady employment. The first tinder of this wildfire was placed in 1938, when then-president Franklin Delano Roosevelt created the Federal Home Mortgage Association (a.k.a. Fannie Mae) "to help people buy homes and encourage the building of affordable housing." After Fannie Mae was privatized in 1968, Washington intervened in the market once again to facilitate the establishment of brother institution Freddie Mac "to expand the secondary [i.e. securitized]mortgage market." While both companies were supposedly independent private corporations, their close association with Washington attracted the same triple-A credit rating as the U.S. Treasury, and they clearly acted as federal policy arms.
Over the years, Fannie Mae and Freddie Mac's government-encouraged easy credit practices spread throughout the U.S. financial system. Even people with prime-rated first mortgages were swayed by easy money and ever-rising house prices to take "second lien" mortgages to renovate their homes, buy a car or simply splurge in what turned into the greatest debt-fuelled shopping spree the world has ever seen. Credit card issuers rushed to join the easy money fray. Consumer debt continually set new records. Combustible material was piling up everywhere, waiting for an ignition source. That spark was the first major downturn in house prices since the Great Depression.
When homes fell to values below their mortgages, people simply stopped making payments, often getting months of free rent before foreclosure. Those who had signed adjustable-rate mortgages, offering low initial "teaser" rates, found their monthly payments notching upwards. As more and more people abandoned their mortgages, the housing market collapsed, and the fire raged out of control.
The mortgage meltdown was serious on its own, but was initially confined to the U.S. housing and finance industries. How did it become a national and then global economic conflagration? It spread through other structures which packaged combustible mortgages with other assets and derivatives. These securities, including collateralized debt obligations (CDOs) and structured investment vehicles (SIVs) were sold to investors secure in the knowledge that they had been assigned the financial equivalent of the highest fire protection rating by credit agencies - triple-A. Amazingly, the world's most sophisticated financial experts, including the storied gnomes in the Union Bank of Switzerland, believed that these structures were inflammable.
Now, the fires rage on and the world's political leaders have turned into ad hoc firefighters. But if the managers and boards of sophisticated global financial institutions failed to comprehend the nature of these devilishly clever financial structures, what chance do politicians and the general public have? Some think we need to move away from free markets to strong government controls. But, as illustrated in the Fannie Mae and Freddie Mac debacles, it was the hand of government that helped create the original kindling for the big fire. Bitter experience with socialist policies has demonstrated time and again that the proper role of government is to set the rules, and leave playing the game to the private sector.
That raises the question as to whether current rules are adequate. Well, how could they be? The financial world has changed dramatically. A year or two ago, how many of my readers had ever heard of credit default swaps? Now there are trillions of dollars worth of these instruments traded globally. They have become a crucial element of today's debt markets because they provide insurance in the event a debtor fails to pay.
Unlike a stock market investor, the purchaser of a credit default swap must rely on an individual counterparty to make good on the obligation. The time has come for a regulated clearinghouse for credit default swaps.
Some are calling for regulation of all derivatives trading, but that could be both impractical and counterproductive. What about those now notorious CDOs, and SIVs? Perhaps there is some regulatory role, but the plain fact is that this conflagration has burned so deeply that investors will no longer buy super complex securities they don't understand. And the Wall Street brokerages that survived have either been bought by or converted into traditional banks, which are subject to much stronger reserve obligations and other regulatory requirements.
There will be no longer be a market for instruments that only the young geniuses from Ivy League business schools understand, so the best and brightest will need to find real economy jobs that actually benefit society. It will be a simpler, more financially fire-resistant world. Mrs. O'Leary would have liked that.