The Global Financial Crisis - Lesson in Risk Analysis

Saturday, March 7, 2009

Introduction: The "Meltdown Hoedown" Understanding the Root Causes of the U.S. Financial Crisis - #1

"The Meltdown Hoedown"
Copyright 2009 Michael C. J. Crowley, All Rights Reserved

"If you want to dance with the devil, you have to pay the piper" .

"meltdown" –noun. - (Informal). A disastrous or rapidly developing situation likened to the melting of a nuclear reactor core

"hoe⋅down" –noun. - a community dancing party typically featuring folk and square dances accompanied by lively hillbilly tunes played on the fiddle, where the dancers are often cued by a "caller" so they dance to a specific movement.

During the Bush presidency, "W" was our square dance economic hoedown "Caller in Chief". The entire nation spent two presidential terms dancing to W's favorite tunes extolling of the joys of trickle-down economics and tax cuts. Elected twice in close contests, most voters saw President Bush as an engaging personality with firm convictions. Certainly conservatives were initially supportive of his fiscal policies. Many detractors, however, saw Bush as merely an energetic wise-cracking Yale frat party boy who failed to properly manage, or perhaps even understand, the complexity of globalized economic world or the vast executive bureaucracy he controlled. He was fun - the President we would most like to have a beer with.

Regardless of whether you liked or disliked Bush's personality or policies, he was entirely consistent in one area - his desire to use the "Reaganomics "supply-side formula of tax cuts and tax rebates as the primary fuel to stimulate the US economy. Bush also guided the administrative arms of the government down a clear path towards reduced government interference regulation and oversight of our financial markets - set the capital markets free and the economy would fly.

Under Bush, the US economy lived or died by trickle down policies. Bush pushed three massive tax cuts through Congress in each of his first three years as President - Economic Growth and Tax Reform Reconciliation Act of 2001-$75.80 B., Job Creation and Worker Assistance Act of 2002 - $52.00B., and Jobs and Growth Tax Relief and Reconciliation Act of 2003 - $60.80B - for a grand total of $188.10B. Tax cuts as a percent of national income tax cut as a percent of national income (as measured by the Net National Product) was 2.0% for Bush. Source - see http://www.taxfoundation.org/news/show/323.html.

The net result of the Bush tax cuts was the transfer of 67.7% of the tax cut ($114.63B of the $188.10B cut) to the top 20% of income earners ($68,296 and above). The top 1% of all income earners ($335,475 and above) received 26.2% of the total Bush cuts.

How did the Bush tax cuts compare with the Presidents Kennedy and Reagan tax cuts? The Kennedy cut was 1.9% of national income and Reagan's cut was 1.4%.

So, with the transfer of $114.63 Billion from the US Treasury to our top 20% income earners, we should have seen more than a trickle down to the rest of the nation - right? There should have been a veritable Niagara Falls pouring down on us all after 2004. Still waiting for your supply-side economic theory trickle?

According to a non-partisan Congressional Budget Office study released in 2007. The biggest winners in the Bush tax cut game were families earning more than $1 million. This group saw their federal tax rates drop more sharply than any group in the country as a result of President Bush’s tax cuts. Bush referred lovingly to this group as his "Base."

Based on an exhaustive analysis of tax records and census data, the study reinforced the sense that while Mr. Bush’s tax cuts reduced rates for people at every income level, they offered the biggest benefits by far to people at the very top — especially the top 1 percent of income earners. http://www.nytimes.com/2007/01/08/washington/08tax.html?pagewanted=print

How has supply-side economic theory held up after viewing the Bush Years? In the words of Nobel Prize winning economist Professor Paul Krugman "Old-fashioned voodoo economics — the belief in tax-cut magic — has been banished from civilized discourse. The supply-side cult has shrunk to the point that it contains only cranks, charlatans, and Republicans." http://www.nytimes.com/2009/01/19/opinion/19krugman.html?_r=1

Many of my clients and seminar attendees have asked that I create this blog to update them on the crisis and about my views on the stimulus packages in the US and China - so here it is! In the near future, I will provide a Mandarin version of my blog. I also plan to add other viewpoints that hopefully will be penned by top Chinese economists and experts. Stay tuned.

Posted by Michael C. J. Crowley at 8:58 AM 0 comments

Labels: financial crisis, globalization, Hu Jintao, meltdown economics, Michael C. J.Crowley, Obama, Shanghai Institute, Triway, U.S. China Economic Stimulus

Tuesday, March 17, 2009

The First "Tsunami Bubble" & The Failure of Bush Economic Theories

With the first plank of the Bush platform, supply-side economics, resting on shaky ground, how then has Bush's desire to reduce regulatory "interference" in our financial marketplace worked out for our economy?



If our job was to detmine the extent of negligence in collaspe of the Bush economy, a fairminded jury would probably conclude that Bush's economic and regulatory polices have been equally at fault in this crash.



For nearly eight years, Wall Street received a very clear regulatory message that when it came to Bush's regulatory and enforcement policies - less was more.



The US financial industry saw this environment of reduced regulatory oversight as evidence that it was time to take additional financial risks to maximize profits, radically increase management’s salary and bonuses. In this new financial marketplace it was “free drink night" at the Wall Street version of risk party central for exotic investment products packaged as Collateralized Debt Obligations ("CDO's).



A favorite CDO product for investors around the globe seeking higher yields was packaged subprime mortgages. Investment bankers enjoyed their newfound freedom from serious regulatory oversight by flooding the market with new "innovative" financial products.



The most incredible innovation involved magically turning toxic mortgages into high grade investment securities. Surprisingly, Main Street America seemed to love Wall Street's crazy binge drinking economic hoedown too as their personal stock market portfolios soared in value and their housing prices reached record levels.



This old-fashioned hoedown was as exciting and exhilarating as it was dangerous. We were told, however, that we need not to worry, supply-side economics works for all. Soon the tremendous wealth that had been created at the top levels of the economic spectrum would trickle down to the middle and lower classes.



If supply-side economics theory could really ever work, this was The Bush presidency was so focused on the validity of supply-side economics, his two terms served to prove one and for all whether this economic theory was valid. Clearly, as practiced by Bush, it doesn't work - no trickle down success.



In this period of reduced regulatory oversight and excess greed, the lessons being taught were that "Greed is good" and spending cures all ills - governmental or personal. The Bush rhetoric decried the expansion of the government and deficits while building up a deficit that exceeded $1.0 Trillion. Tax cuts, plus spending increases - a supply-side receipe for disaster.



These old Bush tunes were certainly catchy. Little did we realize that this new Bush inspired dance tune was actually called - the "Meltdown Hoedown."



Most observers mark September 15, 2008, the day that the once mighty and powerful investment banker Lehman Brothers filed bankruptcy, as the day that the "music died". With the fall of Lehman the wild no-holds-barred Wall Street hoedown effectively came to a screeching halt.



Clearly, however, by the time Lehman crashed, the reality of the subprime fiasco was already a topic of much debate and concern. Lehman's bankruptcy, or perhaps the mere fact that Lehman was allowed to go under, sent the financial world into shock. The initial shock of Wall Street's September meltdown in virtually all US financial sectors has now worn off.



Shock became temporary paralysis that has now been replaced by fear bordering on terror. According to a World Bank report issued this weekend, the US downturn is dragging the rest of the world into a sharp downturn. http://www.washingtonpost.com/wpdyn/content/article/2009/03/08/AR2009030801216.html?wpisrc=newsletter.


The most shocking part of the abrupt collapse of Wall Street titans was that it appeared that the entire world expected the dance to last forever - all boom and no bust. Or......

• That US housing prices could continue to rise without any ceiling?
  
• That US consumers could continue to spend and borrow our way to economic prosperity?
  
• That huge trade deficits do not really matter?
  
• That our manufacturing base could be shipped off-shore and manufacturing jobs being replaced by .... what?
  
• That technology-based productivity gains by US industry and workers would somehow simultaneously reeducate workers displaced by productivity?
  
• That the world's first major middle class, an invention "Made in the America", could suffer a steady decline while carrying the world's growth on their backs?
  
• That the massive growth in wealth and income of the top 1% of Americans would trickle down to the middle class in the form of new high paying jobs?
  
• That increased home ownership at any cost is a good thing for either the US economy or for the US housing market?
  
• That subprime mortgages really were AAA credit after all?
  
• That Wall Street would self-regulate?
  
• That major investment credit rating services would opt to ignore major profit opportunities that could be gained from playing in the subprime market rating game while retaining rating integrity?
  
• That massive tax cuts and rebates in three successive years, 2001, 2002 and 2003, would create real economic growth and prosperity despite the simultaneous vast increases in government spending that saw the deficit grow to over $1.0 Trillion at the close of the Bush presidency?
  
• That tax cuts during a costly war that will cost over $1.0 Trillion could make perfect sense - as long as we used the new Voodoo Economics of "off- balance-sheet" financing?
  
• That the Federal Reserve Board could safely turn a blind eye towards the impact of $3.0+ Trillion of subprime lending on the US financial industry while encouraging the creation of unregulated investment instruments like Collateralized Debt Obligations (CDO's)?
  
• That the formation of the North American Free Trade Agreement (NAFTA) between the US, Canada and Mexico (1/1/1994), the entry of China into the World Trade Organization (12/11/2001) and the explosive economic growth of India could all occur within less than a decade without any major disruption to the US economy?
  That we could safely put the future of our economy built on the ever increasing use of foreign oil in the hands of an oil cartel and Russia?
  
• That a sound energy policy could be summarized simply as "drill baby drill"?
  
• That up is down and down is up? That black is white?
  

Where have you gone Alice in Wonderland - a nation turns its lonely eyes towards you?

We all enjoyed the dance, danced until we couldn't dance any long and stumbled to our knees in exhaustion. For years, we have been dancing with the devil of unplanned globalization, undercapitalized financial institutions and global economic imbalances of every kind and character.

The truly amazing thing about just dancing as hard and fast as we can is that even when we out of condition - the pain doesn't really hit until the dance is done.

• We danced to a wild merry tune.
  
• The dance is over now.
  
• The world is in an economic crisis.
  
• We had our dance with the devil ...
  
• It's time to pay the piper!

It is also time to get up from our knees on the dance floor - take a good long shower - put on a fresh change of clothes and learn to dance to some new tunes.

We need new ways of understanding our global interconnectedness. We need new ways of working together that will actually lead to long term success in our newly globalized flat world. We need new forms of corporate governance and national governance that use globalized risk analysis in each sector of our economy that account for the global complexities of the modern economic world.

In short, we need to totally rethink the basic issues of our global economy in a manner that accounts for the a new world where the combined GDP of China and India in 2050 is projected to equal 50% of the world GDP versus its current combined world GDP of approximately 16%.
The year 2050 will be upon us in the blink of an eye and as we open our eyes in 2050 we will likely see that India's population will exceed 2.0 Billion making it larger than China by a factor of nearly 20%. Are we prepared for this new world? To date, our international economic plans have failed to account for the complexity of a globalized marketplace where money flows freely across borders creating deadly bubbles in the wake of a financial tsunami of investment that can target a single economic sector in a single domestic economy.

This tsunami of international investment rushed into an already super-heated US housing industry from all points on the globe causing the housing price bubble to explode with an unexpected ferocity that literally crushed the US and world financial markets.

Instead of having to manage our way out of a "typical" domestic supply/demand bubble in the US housing market like the ones we experienced in the 1970's and 1980's, we ound our nation in a globalized "Tsunami Bubble".

How did we dance so hard and so long without the hoedown "caller" regulating the pace, changing the dance or at least calling for a break? How could we not have understood the incredible danger posed by the housing Tsunami Bubble?

Even as the world was waking up to the reality that the US economy was being pushed into a downward spiral, President Bush and Treasury Secretary Paulson keep on 'calling" the dance with the same mantra - "The fundamentals of the economy are strong."

Really? Not exactly!

This global meltdown dance has made us all dizzy and confused even as the debris flying around us whirled to a stop. Most were left dazed and wondering what happened. A select few economists, however, saw the meltdown coming and sent out warning signals, but most such truth-tellers were ignored or marginalized.

I too had danced as long and as hard as the next person, but I stepped off the dance floor to return to law school in 2004 to pursue a Master of Laws Degree in International & Comparative Law (LL.M.). Taking this educational break was rewarding and refreshing. My decision to take taking a two year break from the dance gave me a chance to reflect. I was able to stop and think about how globalization has impacted our lives, without impacting our laws or regulations.
I believe that my "dance break" allowed me to use my knowledge of the mortgage and real estate housing industry to gain a very good fresh perspective on what was happening (or was about to happen) to our US and newly globalized economy. It also allowed me to see how our out of control dance would leave the world on the floor in one big sweaty heap of humanity spun out of control.

The clearest warning signals were sent out by several of our top economist in the housing sector - the largest sector of the US GDP hovering right around 12.4 %. All theses danger signs were there for all to see. These warning signs literally screamed out from the work of authors such as Professor Robert Shiller - that this "Tsunami Bubble" was about to burst.

For some laregly unexamined reason, virtually all of our nation's top economist failed to note the storm warnings hidden in plain sight. Why were they ignored? Or were theses signs made invisible by the sheer complexity and size of our globalized economy.

After lecturing for the past two years to 40+ Chinese banking and business delegations to the US on the root causes of the US financial crisis and the potential impact on the Chinese economy resulting from our crisis, I have decided to take another brief break to write a book on my insights into the global meltdown from both a US and Chinese perspective. I hope this second break will again allow me to clearly view the destruction caused by the meltdown with an eye towards giving better advice on stimulus and recovery issues facing us all. I also wanted to share my thoughts with my Chinese friends and clients in a way that may lead to a more open and public dialogue between the US and China.

I firmly believe that a highly detailed analysis of the root causes is critical to a proper analysis of the stimulus efforts by both nations. I hope that this blog will provide a forum for the thoughtful analysis of this first globalized recession, not for the purpose of laying blame but for the purpose of avoiding the mistakes of the past and remaking a better future where globalization works for us all.

We can never turn back the clock on a globalized future, so it is time to build a better clock.
It is now generally understood that the spark that created the global financial meltdown was lit by the so-called "Subprime Mortgage Crisis" that preceded or perhaps presaged this global recession.

The subprime crisis was clearly not, however, the real root cause of the global meltdown, but was rather the "Caged Canary Bird in the Coal Mine." The subprime mortgage market was simply the first canary to die due to the toxic governmental and regulatory policies that had poisoned the economic air we all breathe.

In the face of our current economic debacle, we have not only discovered that the world is truly flat, but I believe that we have also discovered that the economic globe is more like a coal mine that a blue ball floating in space.

Today everyone in the world breathes the same air literally and figuratively. Nothing is better evidence of the fact we are all laboring in the same coal mine than the stark reality of the global impact of the US financial meltdown.

Are there really purely "domestic" meltdowns in major economies any longer?

The globalization of the risk in a world without financial borders suggests that if even one major nation creates severe economic toxicity or major a major bubble fueled by global investment, the global economic environment is at risk. For most outside and independent observers of this crisis, their principle questions have been "How could so many of the world's top economist and government economic officials have failed so miserably in forecasting this meltdown?" and "How could the meltdown spread so quickly throughout the world?"

I believe that far too little serious analysis is being given to both of these questions, especially the critical question of how did so many of our leading economist miss the warning signs that seemed to me to be so clearly evident. The solutions to the crisis lie within our understanding of the root causes of this financial crisis that started here in the US.

Unlike most other financial industry consultants or economic advisors, I did, in fact, see the signs of this crisis coming well in advance of the crash. After studying the economic weather conditions that seemed to predict a coming "Perfect Storm", starting in January 2006 I began advising my clients that the "sky was falling".

My "Chicken Little-like" meltdown analysis was the fruit of the first large scale independent consulting project that I took on shortly after I launched my new international consulting service business. My first client was a firm that was very familiar with my background in the mortgage banking market and particularly the eTechnology used by financial institutions working in all phases of the mortgage industry. This first major consulting assignment was to provide a client a full analysis of not only the health of the subprime mortgage industry participants, but also the future of the major players in the mortgage banking industry.

I have been involved in the real estate, banking and mortgage banking industry since I took my first professional job 34 years ago as the Assistant General Counsel of Fleet Mortgage Corp. (then the second largest mortgage banking firm in the US) a subsidiary of FleetBoston Financial (merged with Bank of America in 2004). My long career in mortgage banking and banking that has included serving in executive positions such as V. P. & General Counsel, Managing Director and President & CEO of financial institutions, investment and venture capital firms. About half of my career has been as focused primarily a full-time practicing lawyer and the second half of my career has been spent primarily as an executive, entrepreneur and the founder of several financial industry technology development firms. In my role as a high-tech entrepreneur I created a series of eTechnology Internet-based fully interactive real time innovations that led in the creation of the eMortgage world (including the launch of the first interactive eMortgage banking Hub and loan origination systems and network and a related consumer direct online mortgage firms, MtgNet Technologies, MtgPro, Situs Technologies and AmortgagePro.com.)
As I mentioned earlier in this blog, in 2004, I left my day-to-day position as managing director of the online mortgage technology and mortgage origination firms I had founded more than a decade ago. My role as a leader and pioneer in the eFinancial world was recognized in 2003 when I was named as the eBusiness Association Executive of the Year.

My return to academia in 2004 was the first time I was away from the mortgage industry in over two decades. This hiatus allowed me to return to law school to obtain an LL.M in International & Comparative Law from The George Washington University Law School and focus upon international eCommerce and eBanking issues with an emphasis on China legal and economic issues. While attending law school, I briefly returned to the practice of law as Special Counsel to Buckley Kolar, LLP, a D.C. based boutique financial industry law firm.

Following the completion of my LL.M studies in 2006, I formed International eFinancial Advisors and International Legal Advisors, both D.C. based independent legal and financial services/eCommerce internationally focused consulting firms. For the past several years I also served as a member of the Gerson Lehrman Group's Financial & Business Services Council.
After I returned my attention to the mortgage industry after nearly a two year absence, I was shocked to learn how Wall Street had become such a major player in the mortgage marketplace. I was equally surprised and dismayed to learn that the Wall Street created and packaged subprime mortgage backed CDOs had ignored key underwriting guidelines that had protected mortgage investors for the past fifty years.

Wall Street's role in the creation of this new bred of subprime mortgage products was unprecedented and their efforts to meet the demand for their "no risk" high yield AAA mortgages had flooded the market with toxic debt and in the process driven housing demand and ownership to record levels.

After spending several weeks reviewing the state of the subprime marketplace and the housing bubble, I combined the analysis of Professor Robert Shiller on the housing bubble with my own in depth knowledge of the inner workings and economics of the mortgage banking industry. In February 2006, I created an expanded analysis of the subprime market and mortgage banking marketplace that not only predicted the total collapse of the subprime market players, but also the likely downfall of the mortgage market leaders, Countrywide, WAMU, IndyMac and Fannie/Freddie.

This updated version of my "housing bubble analysis" included the impact of increased oil imports, growing trade deficits, the decline in our manufacturing sector, the increased levels of consumer debt and the impact of a complete housing meltdown on our overall economy - result - a severe recession the likes of which we had not seen in my lifetime. My client, a major international investment banking and consulting firm, read my report and listened closely to my analysis. For the most part, however, the senior partner of my client's firm felt that although my analysis was well researched, my dire predictions had overstated the problem and misjudged the potential impact of the danger of the Wall Street version of subprime lending on the housing industry.

Despite my client chose to ignore my opinion, it was my firm belief that by combining Professor Shiller's remarkable analysis of the housing bubble with my own unique understanding of the economics of mortgage banking and real estate that it was crystal clear that the housing market would collapse.

The US had experienced housing bubbles before and had seen the effect of the bursting of these bubbles. My prediction was that this current bubble would pop and thereafter behave in almost the same manner as our 1970's and 1980's housing bubbles burst. After each of our earlier bubbles had burst in housing, the housing price market returned to virtually the same point at which the boom had started. Each rise and fall was marked by a very sharp curve up and a rapid fall. Each boom and bust in housing did major damage to our financial sector wiping out most of the savings and loan industry in the process.

The 70's and 80's housing bubbles were relatively minor in size and scope when compared to the housing boom that extended from 1996 - 2005. This new Tsunami Bubble saw real housing prices rise by nearly 90% (as adjusted to eliminate inflation as measured by the S&P Case Shiller US Home Price Indices), In light of the enormous size of this bubble, it was logical to conclude that the housing collapse would pull down the entire US economy that was already in a weakened state for many other reason.

This latest housing boom had, in fact, served as the mask hiding the other real and serious problems that had already spread thought-out our economy. Unlike the housing bubbles in the 70's and 80's that were driven in large measure by the movement of the baby boomers into the housing market (a natural and logical supply/demand issue), this housing boom that started in 1996, this boom was driven by Wall Street intervention from 2003 - 2006.

After Wall Street discovered subprime lending, Wall Street infused of trillions of dollars of foreign investments into the mortgage market using unregulated Wall Street funding mechanisms. The housing boom was probably ready to fall of its own weight in 2002 if Wall Street hadn't added its own version of "rocket fuel" to the fire.

To make matters far worse the Wall Street products driving the boom were built on untested, unproven mortgage instruments using illogical projections of continuous annual housing price growth of 5% or more.

All was not lost with my loss of this first client, as I now had a significant economic discovery in hand; however, I did not have any other financial clients interested in my gloomy research and analysis that had so radically contradicted everything that they seemed to believe with an almost religious conviction. Fortunately, one year or so later, I did find an audience that was willing to listen to my analysis - China.

In early 2007, I was asked by Triway International Group in DC to speak to two delegations of senior Chinese bankers on the issue of eBanking in "flat world" and globalization risk analysis. Although the focus of my two day-long lectures for Triway was eBanking, risk analysis and the impact of foreign banks on the Chinese banking industry, I took the opportunity to provide 60 banking executives with my analysis of the meltdown of our housing industry leading to a collapse of the financial markets led by the toxic subprime market.

After leading both of the Chinese banking groups in a very "spirited" discussion, I continued to take them through my detailed housing bubble analysis that showed that the collapse of our housing bubble would lead the world into a global recession. As I discussed the issues of the financial crisis in the context of international banking with the members of these Chinese banking delegations, it became very clear to me that the principle that drives international banking - balance - was lacking in most areas of our economy.

Our US economy was seriously out of balance in our trade with China and other nations; out of balance as our middle-class seemed to be in a downward spiral along with our manufacturing sector; out of balance in our use of energy and reliance on foreign oil; out of balance in our regulatory environment and out of balance in our near total reliance on the unproven economic strategy of supply-side economics.

Our seminar covered the historical results when national banking markets had gone seriously out of balance and how in such events bad results are sure to follow. Domestic banking imbalances are always corrected by the marketplace, but unlike other eras, the financial marketplace that had become out of balance was the globalized financial market not a domestic banking market.

An analysis of banking data demonstrated that capital was clearly not being adjusted for the global risks; the international financial institutions were vastly undercapitalized given the levels of risks associated with the various huge housing price and oil bubbles. These toxic bubbles were growing more lethal with each passing day.

Fortunately, the Chinese banking seminar participants quickly understood the potential danger posed by the US housing bubble and were anxious to learn more about the impact of the bursting of the US housing bubble on both the US and Chinese economies. Unlike my US client in 2006, the Chinese banking seminar group leaders and attendees quickly understood my analysis and with the benefit of the hindsight that the US housing prices were continuing to spiral downward as projected, I began to focus nearly all of my professional efforts on the task of advising Chinese businesses and delegations on my analysis of the US financial crisis.

Over the past few years, I have been appointed as a Senior Advisor to Triway and have presented over 40 day-long lectures on my analysis of the root causes of the US financial crisis to visiting Chinese delegations and clients. During the past two years I have continued to refine my analysis and have greatly expanded the scope of my lectures to include the potential impact on the Chinese economy and issues related to the economic stimulus efforts of both the US and China. In November 2008, my work with the Chinese delegations led to a lengthy appearance on Quangdong TV as a part of their 2 hour special report on root causes of the meltdown and the impact of the US financial crisis on China.

Posted by Michael C. J. Crowley at 8:08 AM 0 comments