On March 23, stocks were headed for a fabulous 7 percent gain. The Obama administration had just come out with a program in which private investors could buy toxic bank assets by putting up almost nothing; the U.S. government would ante up more than 90 percent of the dough. It was a case of no risk and huge rewards; Wall Street was exultant. The president’s economic guru Larry Summers deadpanned that the market was reacting favorably to the program — but, gee, the government really didn’t worry about the stock market, he intoned, as his nose grew to three feet long.
The federal government has been manipulating the stock market since the beginning of Alan Greenspan’s term at the Federal Reserve in 1987. Indeed, the March 23 bribe offer to Wall Street was a cynical attempt to run up the market to bolster consumer and business confidence and gain support for the administration’s plan. In almost every major economic step it takes, the government has one eye on the market. In March of last year, Wall Street’s Bear Stearns was rescued. The Bush administration rushed to get the job done before Asian stock markets opened.
Much as you would like to see stocks and housing values recover, you should not wish for any fast, government-manipulated recovery. That’s exactly what got us into the trouble we are now in.
For three decades, we have been living in a world dominated by a short-run, fast-buck mentality. Buy today, flip tomorrow. Risk? Forget it. The government will do everything to keep stock and real estate prices rising — you make bets with chips provided by the government.
That works splendidly for a while. But there is moral hazard — the verity that a party insulated from risk will eventually act recklessly, leading to a crash and shifting the responsibility to clean up the mess to others (usually taxpayers). Governments have found to their sorrow that while they can help manipulate markets for long periods and to breathtaking heights, they can’t support prices that reach loco levels. In this decade alone, we have experienced two stock market crashes and one real estate crash.
Consider the stock market. Believe it or not, in the 1940s, 1950s, and early 1960s, companies were built for long-term sturdiness. Corporate managements and Wall Street were generally not obsessed with short-term performance. It was believed that if managements succeeded in building a sound company, the stock price would take care of itself. Generally, accounting was straight and debt levels were moderate.
During the 1960s, crooks invaded the scene in the form of conglomerates that would inflate earnings and stock prices by cooking the books, then use bloated stock for takeovers of reputable companies. Most collapsed, but not without wreaking havoc. San Diego had some doozies: C. Arnholt Smith’s Westgate-California, U.S. Financial, and Intermark, for example. In the 1980s came the takeover crowd that raised money through junk bonds and raided respectable corporations, which too often fought back by loading themselves with debt and cooking their own books. Both the conglomerates and takeover crowd were often backed with dirty money.
So the takeover targets resisted, and tragically, that’s when once-reputable blue-chip companies began adopting the same slimy methods as the crooks — using every trick in the book to run up the price of their stocks. What began as self-defense became de rigueur. Wall Street insisted that companies keep growing every quarter. So, using sharp pencils and efficacious erasers, they did. San Diego’s Peregrine Systems was one of the most egregious offenders — backdating contracts, drawing up fake sales, for example.
The government did its part to keep stocks zooming. It set up 401(k) and individual retirement accounts to make stocks more attractive. It handed out all kinds of tax breaks to corporations and loosened rules so companies could wring maximum advantage from offshore tax havens. The Federal Reserve kept money easy to facilitate financing. Not wanting to take away the punch bowl, the Securities and Exchange Commission stopped riding herd on major fraud.
On October 19 of 1987, stocks, which had been in a rowdy bull market, plunged by 22.6 percent. The next day, professionals worried that the whole global financial system would unravel. Suddenly, there was heavy buying of stock market futures contracts, pushing up the popular averages. Sophisticated observers knew that either the government or central bank was doing the buying or ordering big banks to do it. The stock market quickly recovered. Bingo! The government realized how easy it was to manipulate stocks. On March 18, 1988, President Reagan formed the Working Group on Financial Markets, which came to be known as the Plunge Protection Team. Its mission is hush-hush, but Wall Street insiders know it is the bulls’ quarterback.
Financial consultants and stockbrokers picked up the signals. Individual investors were told to have 60 to 70 percent of their portfolios in stocks, instead of a more rational 30 to 45 percent. Ditto for pension funds, which should have known better. Companies told their employees to load up their 401(k) portfolios with stock mutual funds. Meanwhile, Wall Street cranked out all kinds of exotic and oft-inscrutable products that the public gobbled up and regulators ignored.
As debt exploded, so did profits. So the government encouraged excessive debt. On April 28, 2004, the Securities and Exchange Commission blithely decided to let major investment banks raise their debt levels to, say, 33 to 1: for every dollar of equity, a Wall Street firm could have a staggering $33 of debt or more — far, far more than was permitted under old net capital rules.
Stocks soared through the 1990s, basically on artificial levitation. But then came a bear market, a moderate recovery, and the bear market we are now in. One reason for the current unhappiness: the institutions that supposedly did the buying for the Plunge Protection Team — big Wall Street institutions — are now broke, in part because of the excessive debt that the securities commission let them have and in part because of complex derivatives that the government did not regulate.
All around the world, other countries were adopting the U.S. model. Now markets are plunging together all around the globe. To a very large degree, moral hazard is the reason. Once investors and investment professionals believed governments could and would hold up markets, lunatic decision-making proliferated. And led to the crashes that the government could not stop.
After the bursting of the tech-stock bubble in 2000–2002, the Federal Reserve needed another bubble. It lowered interest rates to the floor. In previous years, Congress had made many steps to encourage home ownership: tax breaks, creation of Fannie Mae and Freddie Mac to buy mortgages and sell them to investors. Politicians hyped home ownership of low-income families by encouraging issuance of subprime mortgages and peddling of them to investors. The country set itself up for a nuclear explosion: lenders didn’t care whether a borrower could afford a mortgage; after all, it would be sold to Wall Street and then to investors. The paper was peddled in the form of highly and deliberately complicated derivatives containing those mortgages.
San Diego, which had always had high home prices and moderate incomes, was on the leading edge — of the precipice. Citizens snapped up mortgages with teaser rates that would later balloon. San Diego became the capital of exotic mortgages. Foreclosures cascaded. Prices have plunged more than 40 percent since their 2005 peak — one of the biggest declines in the nation.
Now San Diegans’ stocks and home values are down 40 percent or more. And the government intends to prop up both. You may think that’s good news, but it’s bad news for long-term stability and sanity. Moral hazard makes it so.