One Economic Narrative

Wall Street Journal columnist Holman Jenkins Jr. tries to trace the cause of the credit crunch in the June-July Hoover Institution Policy Review:

[I]t isn’t true that Wall Street made these mortgage securities just to dump them on them the proverbial greater fool, or that the disaster was wrought by Wall Street firms irresponsibly selling investment products they knew or should have known were destined to blow up. On the contrary, Merrill Lynch retained a great portion of the subprime mortgage securities for its own portfolio (it ended up selling some to a hedge fund for 22 cents on the dollar). Citigroup retained vast holdings in its so-called structured investment vehicles. Holdings of these securities, in funds in which their own employees personally participated, brought down Bear Stearns and Lehman Brothers. AIG, once one of the world’s most admired corporations, made perhaps the biggest bet of all, writing insurance contracts against the potential default of these products.

So Wall Street can hardly be accused of failing to eat its own dog food. It did not peddle to others an investment product that it was unwilling to consume in vast quantities itself.

Nor is it true that Wall Street executives and CEOs had insufficient "skin in the game," so that "perverse" compensation incentives created the mess. That story also does not pan out. Individuals, it’s true, were paid sizable bonuses in the years in which the securities were created and sold. But most also had considerable wealth in the form of stock and stock options in their firms, which bet their own capital on these securities. Many also appear to have invested directly in funds to hold the subprime securities.

They had skin in the game. Personal losses to top executives in banks that failed or whose share prices collapsed were in the millions, hundreds of millions, and in some cases billions of dollars. . .

It isn’t true, either, that Wall Street manufactured these securities as a purblind bet that home prices only go up. The securitizations had been explicitly designed with the prospect of large numbers of defaults in mind — hence the engineering of subordinate tranches designed to protect the senior tranches from those defaults that occurred. . .

Nor is it plausible that all concerned were simply mesmerized by, or cynically exploitative of, the willingness of rating agencies to stamp Triple-A on these securities. Wall Street firms knew what the underlying dog food consisted of, regardless of what rating was stamped on it. As noted, they willingly bet their firm’s money on it, and their own personal money on it, in addition to selling it to outsiders. . .

Up has gone a cry in the aftermath for some kind of "systemic regulator" to prevent a reoccurrence and spare the political class from having to vote for bailouts in the future -- though, in an evasion of reality, this über-regulator is supposed to spot bubbles and unwise risk-taking before they blow up, sounding a whistle just when investors are at the most enthusiastic lest investors inflict more losses on themselves than Congress will decide in retrospect should have been permitted.

In reality, we already have a systemic regulator -- the Federal Reserve, whose traditional mission, in the colloquial description, is to "take away the punch bowl just when the party is getting started." The Fed has been imperfect in this task in the past and will be so in the future.

What Congress doesn’t want to admit is that it wants not a systemic regulator, but a systemic savior — an institution that can step forward and stop panic in its tracks. But we have one of those too — the Fed again. For all the arguments heard on Capitol Hill last fall that only a $700 billion appropriation stood between us and financial Armageddon, that $700 billion sum has proved a pittance compared to the resources the Fed, under Ben Bernanke, has deployed out of its hip pocket. The Fed has bought unwanted assets and issued guarantees to the tune of more than $1 trillion. It has created untold billions in excess bank liquidity through monetary policy. If we’re honest, the Fed’s ability to print money stands behind the FDIC, which insures the nation’s bank deposits. It stands behind Fannie and Freddie, which are increasingly in the business of losing money on purpose to help the housing market. Even the U.S. Treasury has been edging sideways toward relying on the Federal Reserve to finance the exploding national debt.

We have a systemic savior -- the Federal Reserve. And all that remains to be seen is how much its efforts this time will ultimately cost in the erosion of the purchasing power of the U.S. dollar.

I'm not sure I concur with all of Jenkins's analysis, but read the whole thing. And see Arnold Kling.

(via The Corner)