I work in the financial industry, so naturally I get asked my opinion on the current market turmoil. What's my first reaction?
DON'T PANIC
That's right. These are uncertain times, but that's exactly when calm is required. Let's get right into it.
Lehman Brothers: First, I feel for my many friends at Lehmans who have had their equity stakes wiped out and who are at risk of losing their jobs. But should Lehman's have been bailed out? No. Lehman Brothers is a private entity that made bad business decisions, and the stakeholders in that business must now wear the pain. Something was fishy for a while, as pointed out by the many analysts who first questioned Lehman's balance sheet. Insider scuttlebut has it that Lehman's risk management was poor. Remember the Asclepius loan fraud issue in Japan? Lehman has been making itself out to be the victim on that one. But equally, why did they entertain a loan to such an entity in the first place? It's another example of bad risk management.
Also, I don't want to hear anything about "golden parachutes" for failed CEOs. Everyone at Lehman Brothers lost all of their deferred compensation that was in shares. Many will also lose other retirement savings and other unfunded liabilities as part of the bankruptcy. Believe me, managers at all levels are paying the price.
Merrill Lynch: This case is different. After Stan O'Neill was ousted, new CEO Thain came in and promptly wrote down bad derivatives and sought capital to shore up the balance sheet. For his efforts, Thain got $50B more for his shareholders than Lehman's got! Bank of America got a good deal as well, filling in a part of its business mix where it was weak relative to competitors like JP Morgan and Citigroup.
Fannie Mae and Freddie Mac: I've said before that the issue here isn't that these entities are too private. Rather, they are too much a special case. The entities get all of the profit when things go well, but have favored regulation and downside protection when things go badly. This hybrid is prone to political meddling and that's exactly what happened. When the Bush administration and also John McCain sought to improve the regulatory situation for Fannie and Freddie, they were roundly rebuffed by powerful democrats in Congress (Dodd, Frank, Shumer to name a few). Guess who was getting the most money from Fannie and Freddie? Well, those very same democrats and Obama too! I won't go so far as to say there was a quid pro quo here, but clearly judgement was clouded.
AIG: well to be honest, this one I'm not sure I understand. Insurance companies are generally required to invest conservatively, but the warning signs at AIG have been there for a while. Should they have been extended loan guarantees? To protect liquidity in the broader financial system, then probably yes. . .but this one I don't really know. It does smack a bit of a bailout.
And by the way, thank goodness for Gramm-Leach-Bliley legislation that broke down Glass-Steagall restrictions. Without it, Bank of America would not have been able to buy Merrill Lynch and the bailout plan that is being worked out now would not have been possible with the necessary speed.
Also, thank goodness for Paulson, Bernanke, and other senior Bush Administration officials who are providing effective leadership. Can you imagine if it were Obama's economics team? Clinton's team might have been OK, but I for one am very comfortable with seasoned and experienced hands at the helm during these times.
And by the way, it is not all bad. The US economy is proving highly resilient. The dollar is up slightly, markets are still up over the long term, interest rates are stable, core commodity prices are down.
The worst thing to do is panic and rush into the wrong action. The next most important things to do is to have a plan for managing the situation effectively. On that point, the Bush administration wins again. McCain is also effective. Obama and the Democrats are clueless as to what to do. Yet another reason why Obama and the Democrats generally cannot be trusted with real power.
None of this is a fraud situation like Enron or Worldcom. At most there was an issue with incorrectly assessing the risk of mortgage-backed derivatives and marketing them as safer than they were - something for which many firms have already paid substantial fines and paid back many investors. No amount of regulation can correct for bad management.
And don't even get me started on that corruptocrat Charlie Rangel. To paraphrase Leno - if the guy that writes the tax laws doesn't understand them, then how screwed are we!
It all goes back to basic principles:
1) Markets work. When bad decisions are made, those accountable for the decisions must bear the loss. Postponing the decision only worsens the pain.
2) Regulation must be clear, effective, and applicable to all. When regulation is convoluted, different for different market players, or beholden to the whim of regulators, there is market distortion, uncertainty and the risk of influence peddling.
3) If something is too good to be true, it probably is. If returns seem better than the risks that underly them, then something is probably miss-priced.
4) Simple is better. The harder an asset is to price, the riskier it is.
My brother-in-law has a good comment on all this: Don't buy something that you don't understand. Good advise in any market.
