San Diegans’ stocks and home values are down 40 percent or more

How about trying a free market?

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.

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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.

There is also another major reason the 5 major investment banks ran a 35-1 leverage ratio-they no longer had their own money at stake. They could take all the risks using stock holder cash.

In the old days all the IB's were private partnerships-much like law firms. But they all eventually went public in IPO's. They all eventually went public-with Godlman Sachs being the last IB holdout, caving in the mid/late 90's.

By using other people's money (the stock holders-"OPM") instead of their own personal money the IB's were happy to leverage at 35-1 because of the "moral hazard" and OPM. Take away the sharehold money for risk and make IB's use their own $$$ and there would be no 35-1 leverage.

Response to post #1: Yes, if the old big investment banks -- now categorized simply as banks -- had been using totally their own money instead of partly investors' money, they probably would have been less reckless. Best, Don Bauder

Response to post #3: Great. Stock market chartists always talk about head and shoulders patterns. I know what this one can be called but I am not going to print it. Put it this way: it is the most titillating stock chart I have ever seen. Best, Don Bauder

Getting back to being serious, it might be noted that governmental actions that appear to be minimal and rather weak can have a big impact on markets. I'm old enough to remember the later days of the Nixon price/wage controls in 1973. That was the stage when the challenge was to relax and eventually eliminate the controls. Every time a rumor of some easing, or whenever there was actually some easing, the stock market would dip for that day and often for a number of days. That meant that the markets had become comfortable with the controlled environment, and were scared by the prospect of additional freedom. This was just the diametric opposite of what free-market advocates would have expected and believed should have happened.

In the long term we were much better for having gotten rid of those ham-handed controls. But while it was happening, their elimination did NOT make participants in the market more confident. What happened was just the opposite. The same sorts of things will be true this time.

Response to post #5: You are absolutely right. In the current crisis, stocks tend to go up when the government announces another initiative to rescue banks, or prop up some other area of the economy (say, autos), or generally pump more money into the system. But stocks tend to move down if there is any hint that the government will take its foot off the pedal. Best, Don Bauder

Response to post #7: It's one of the funnier thing posted on this blog, in my mammary. Best, Don Bauder

Response to post #9: Grammatically, "you're" would be correct, but in a pinch, "your" might be acceptable, depending on the intended meaning, and ignoring awkward construction. Best, Don Bauder

I'm old enough to remember the later days of the Nixon price/wage controls in 1973.

Wow, I was just a little kid when this happened but for some reason I remember it.

I cannot even dream of the President or Congress putting in price controls today.

Tell me, did the Nixon price and wage freezes help?? Did they stop inflation-which I think was the purpose (this was before my time).

Response to post #11: Nixon's price/wage controls probably exacerbated inflation. For awhile, they seemed to hold down statistical inflation, but as soon as they were lifted, inflation roared up. The company I worked for at the time (McGraw-Hill) got around the wage controls by promoting people to a supposedly higher post -- thus justifying a higher salary. But there was no higher post; the person was doing exactly what he/she had done before -- just had a fancier title. All kinds of ways to evade those Nixon controls were used. Best, Don Bauder

Response to post #10: Ok, thanks. Now I've got it: Your boobs both.

Response to post #13: Here's another: whose boobs? Or Who's Boobs? Best, Don Bauder

It's a little known fact, but noted economist Arthur Laffer first conceived of the Laffer Curve while dining at Hooter's. He sketched out the curve on the back of a Hooter's napkin. The napkin is currently on display at the Reagan Library.

Response to post #14: boobs is (oh, no...are?)David Copley's.

Response to post #15: Another case of cherchez la femme. Best, Don Bauder

Response to post #16: David Copley will be so happy to be shielded from such badinage once he sells his company (or most of it) to the Hollywood contingent. Best, Don Bauder

Response to post #18: I'm so confused. Is this yet another case of cherchez la femme? Poor Richie Rich.

Response to post #19: Now you have me confused. If what Burwell says is true, it is definitely a case of cherchez la femme. Best, Don Bauder

Make mine a double, then. Ok, enough. I'm making myself dizzy.

Response to post #21: Double it is. Best, Don Bauder

Economically speaking, I believe the nation's markets are best represented as a boob shaped curve.

While some markets internationally still have perky slopes in their charts and well rounded assets, we've become a bit saggy. This is understandable since we've recently had the financial silicone implants removed.

Economics is fascinating...

Response to post #23: Our advancements in Silicon Valley have been erased by the deflation of Silicone Valley. Best, Don Bauder

11% unemployment in the valley now...a 100,000 techies, nerds, geeks, recruiters and software sales-critters out looking for work.

Response to post #25: San Jose unemployment hit 10 percent in February and is going up. Tech is hurting. Best, Don Bauder

Somewhere in some dusty box I think I've got a copy of your 2005 piece warning of the impending bust. Is it available on-line?

Well, "moral hazard," yes. But this is the excuse the lenders have used to hold onto toxic houses they're letting rot and their pools fester with mosquito larvae, drowned kids, dogs, cats, lizards, ad nauseam, no? Seems insane from a long-term investment point of view to me, but at least there will be some “stimulus” effect for the reconstruction industry . . .

Maybe that’s where I should invest (instead of the banks) so I can join the feast along with all the other maggots?

We've enjoyed 15-20 years of faux prosperity and high living. Unfortunately, we didn't earn it. To get cash for our party, we borrowed from the Chinese and Japanese and stole from most of the world in the form of taking their investment money in return for worthless "securities", all the while taking pride in our new "service economy". Now we find ourselves with huge debts and debt service, dramatically reduced wealth creation capability because so many jobs have been shipped overseas, and increasingly difficult borrowing circumstances. Our credit-card party is ending but the politicians don't want to face it and lead us into more sensible economic practices. Instead, those morons are forecasting highly unrealistic 3.5% GDP growth in the next year and 4.0% for the decade after that and using these "forecasts" to dupe us into further increases in government spending and borrowing. Where does it lead? Into the third world existence that Bauder keeps talking about.

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