The path to 50% wealth reduction

Daniel Henninger:

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How the financial markets fell so far so fast will occupy economic seers for years. The path to 50% wealth reductions and the death of Wall Street was paved with good intentions, notably the notion that all should own a house, even if that required giving away the house to untutored borrowers with low-to-no-interest loans.

This good intention set off history's largest chain of moral hazard. The great unraveling began sometime between 2005 and 2007, when borrowers, lenders and securitizer shamans all found themselves operating in a zero-gravity environment, aloft on moral hazard.

The technical details have been described with harrowing precision by Robert Stowe England in "Anatomy of a Meltdown" for Mortgage Banker magazine. Briefly: "The underwater earthquake that first rattled the foundations of the mortgage industry came in the form of sharply higher delinquencies and defaults from a book of poorly underwritten subprime loans from the fourth quarter of 2005 through the first quarter of 2007."

His narrative runs through borrowers making misrepresentations on loan applications (fraud), the collapse of Bear Stearns's hedge funds, revised ratings-agency methodologies that led to "unprecedented" mass downgrades, causing a contagion that spread from subprime to prime home-equity loans, and a warning from the president of the IndyMac S&L that "the private secondary market is not functioning." This in turn precipitates a "torrent of deleveraging." Here's the best part: Mr. England's chapter-and-verse article appeared in October -- of 2007, one year before the current mass panic.

A more recent, widely emailed article for Portfolio.com by Michael Lewis of "Liar's Poker" fame describes a skeptical hedge-fund manager and his associates walking through the wild world of mortgage-backed securities like stunned characters in "Mad Max," in effect asking bankers, borrowers and ratings-agency executives one question: Why? Why do you think all of you can get rich, all at the same time, forever?

On Sept. 25, a week after Lehman Brothers declared bankruptcy, Nicolas Sarkozy announced, "Laissez-faire is finished." Then the Washington Post asked on its front page: "Is American Capitalism Finished?"

Little or nothing that has occurred through this crisis discredits the system of free-market capitalism. Across several centuries of rising world incomes and social gains, the system has proved its worth. In this instance, the system has been badly used -- by mere people. Nonetheless, the dimensions of the fall and devastation that originated in subprime mortgages are breathtaking.

Amid all these downward-pushing pressures, occurring in plain sight, hardly anyone or anything stepped up to brake the fall. What happened?

The answer echoing through the marble hallways of Congress and Europe's ministries is: regulation failed. In short, throw plaster at cracked walls. Trusting the public sector to protect us from financial catastrophe is a bad idea. When the Social Security and Medicare meltdowns arrive, as precisely foretold by their trustees, will we ask again: What were they thinking?

What really went missing through the subprime mortgage years were the three Rs: responsibility, restraint and remorse. They are the ballast that stabilizes two better-known Rs from the world of free markets: risk and reward.

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In John Steinbeck's Tortilla Flat some "well intentioned" otherwise ne'er do wells decide to help a single mom whe feeds her brood of kids a diet of pinto beans and tortillas because she can't afford a more balanced diet for them. They start stealing food and giving it to her. However the more balanced diet gives everyone diaherrea. the single mom decideds they were better off with pinto beans.

I think that story is a metaphor for the housing mess in many respects. In retrospect most of those who induced to buy houses they could not afford would have been better off without them and it is clear that the rest of us would have been better off if bankers had not been forced to lend to people with bad credit.

The current story is one of how Democrats have used their political skills to avoid paying a price for a monumental screw up by shifting blame to the Bush administration. It is an area where Republicans need some work.