A Crash Course in Crisis Economics*
I. A Refresher on Recent Events and a Primer on Important Terminology
Inside Barney Frank’s district office in Newtonville, a strikingly well-dressed man who happens to be in the business of manufacturing solar panels is patiently waiting to speak to someone on the congressman’s staff. This summer the man’s Marlborough-based company had been working on raising $375 million by selling convertible debt — bonds affixed to stock options — to the public. As a condition of securing the financing, the investment bank handling the offering required the company to lend it some 31 million of its shares. But the deal never went through, because the investment bank was the soon-to-implode Lehman Brothers…a consequence of which was that the well-dressed man’s company, Evergreen Solar, never got its shares back. Barclays, the British bank that bought Lehman’s investment banking division, isn’t letting the shares go, forcing Evergreen Solar into suing to get them back. And so the well-dressed man is here, to learn what other options he might have.
Such are the Kafkaesque scenes that emerge during the complete breakdown of a system, which, you may have noticed, is what we now find ourselves living through. It’s not a situation made for easy comprehension, but when economists and politicos and anyone else with a time-share on the moment try to explain it to us, two big themes tend to come up: "information asymmetry" and "moral hazard." You cannot have a halfway-serious discussion about the economic crash — or, for that matter, American politics generally — without them, and so it is with them that we will begin.
In a market context, information asymmetry is what it sounds like: a gap in understanding between two sides of a transaction. Despite his reputation as a partisan, Barney Frank views political problems through that same lens, framing most as a series of misunderstandings, miscalculations, and misplaced misgivings. He is equally deeply versed in moral hazard, which refers to the tendency of people who’ve been insulated from risk to behave differently (i.e., more riskily). The term was coined in the 19th century by life-insurance underwriters concerned that their customers would be increasingly likely to indulge in unhealthy excess; more recently, it has come to also be used in reference to prolonged stays in the corridors of Washington. Promoted by conservative Republicans, the idea began to take hold roughly 30 years ago — right around the time Frank won election to Congress — that the federal government is a veritable landfill of morally hazardous waste, manned by machine pols unnaturally insulated from the threat of losing their jobs and wanting only to spread the wealth of a risk-free government-payroll life to friends and lazy poor people.
But times change, and with them, the hazards. As when the financial system caved in on itself this September, the casualty of a decade-long ritual risk-burning started by hedge funds and sustained by a long list of all-too-eager accomplices. Within a few weeks, Henry Waxman, the California Democrat and chair of the House Oversight Committee, had hauled in some of the country’s leading plutocrats: Lehman CEO Richard Fuld and a pair of former CEOs of AIG — the insurance giant that had booked billions in profits on policies it couldn’t honor, then went golfing at the St. Regis after the government promised to bail the company out — and finally Alan Greenspan, whose false ideology was the system’s original sin. House Speaker Nancy Pelosi, for her part, gave a speech laying blame squarely on the "recklessness" and "irresponsibility" of "anything-goes" Republican policies. A member of her caucus reportedly wrote an e-mail vowing not to vote for a "$700-billion-dollar giveaway to the most unsympathetic human beings on the planet" unless it was "as punitive as possible" and included curbs on executive behavior "that would serve no useful purpose except to insult the industry." It was astonishing: For once, the Moral Hazard Majority belonged to the Democrats.
Curiously, Frank wasn’t joining it. Hill insiders found it noteworthy that he’d ceded so much turf to Waxman when he could have done his own excoriating of corrupt billionaires in front of the Financial Services Committee, which he has chaired for the past two years. Instead, as Frank’s staff in Washington worked the phones monitoring the minutiae of the bailout package, he returned to his district and ran a campaign for reelection that resembled a lecture circuit as much as anything else. He visited the editorial boards of local newspapers and spoke at chamber of commerce breakfasts, community luncheons, and Democratic Party dinners. In between, he went on what seemed like at least one national news show a day to discuss the Wall Street mess.
"People should not be surprised that people who do not believe in government are incompetent at running it. It’s like making me chief judge of the Miss America contest," Frank said at one of his stops, a fundraiser in New Hampshire, cracking up the audience. It was superficially a partisan speech to a thoroughly partisan crowd. But though those who seek to blame the crisis on him would never believe it, it was also given in pursuit of a higher purpose. "Barney Frank is not a hypocrite," says Larry Lindsey, the former George W. Bush chief economic adviser (who over the summer wrote a column for the conservative Weekly Standard praising Frank’s "intellectually honest" mortgage foreclosure legislation). "He’s been dealing with this crisis in a very positive way. He understands there’s nothing criminal about being wrong." The real hazard, Frank understands all too well, is in failing to try to open the other side’s eyes. A month after securing his 15th term, he continues to give his speeches.
II. Understanding the Upside to Maximum Personal Transparency
In interviews, Frank has generally traced the realization that he was homosexual to age 13. He knew about gays because three years earlier, in 1950, the State Department had fired 91 of them in an episode that touched off a mass government purge of men the newspapers then dubbed "perverts," on the grounds that gays were disproportionately susceptible to blackmail and therefore posed a greater security risk. The rationale was irrational: In communities in which homosexuality is considered taboo, a gay person, by the laws of moral hazard, should have strong disincentive to engage in activity that could invite extortion. In fact, the discretion required to have any sort of homosexual affair in that era meant gays were perhaps better suited to hold sensitive positions (which may help explain why McCarthy employed a closeted gay man, Roy Cohn, as his chief counsel).
Frank, a garrulous slob who loses his cell phone every few weeks (an early campaign slogan: "Neatness Isn’t Everything"), has never been a naturally discreet guy. At the same time, as he entered politics in the 1970s as a young state representative, his pragmatic side could not have seen much benefit to being openly homosexual. His choice of career had been inspired by the civil rights movement, the lessons of which made Frank keenly aware of the cultural sensitivities and unarticulated fears that could turn decent people away from just causes. (During his college days at Harvard, when Frank spent a summer in Mississippi with the Freedom Riders, a reporter asked him whether he thought blacks were the vanguard of a new American Revolution. "No!" he said. "They just want to sit back and relax and have a house in the suburbs like everyone else.") Given the options, he dealt with his sexuality mostly by not dealing with it.
Frank graduated to Congress in 1980; in his first term, about the only thing he earned a reputation for was promise. His colleagues voted him "Best New Congressman." The legendary Tip O’Neill dubbed him a shoo-in for first Jewish speaker of the House.
Then came AIDS.
When the disease emerged as a public health epidemic in 1981, the prevailing conservative wisdom considered it the Almighty’s own purge of homosexuals and heroin addicts; a more apocalyptic-minded contingent saw it as a pox visited on all of America for decades of godless rock ‘n’ roll–enabled permissiveness. Among the latter was California Congressman Bill Dannemeyer, who introduced numerous measures to quarantine AIDS patients. To highlight the unhealthiness of the gay "lifestyle," he read aloud on the House floor graphic descriptions of homosexual sex.
In 1986, the Justice Department wrote an opinion arguing in favor of allowing employers to fire people with AIDS if they feared the disease to be contagious in the workplace. The following year, Connecticut Congressman Stewart McKinney died of AIDS he’d gotten, his doctor said, from a blood transfusion. The next day the Washington Post produced accounts that McKinney, a married Republican, had slept with men. At the funeral, Frank decided he had no choice. It was already well known among his friends that he was gay; rumors had also started to circulate about his relationship with his "houseboy," a sometime escort he paid to drive him around and run errands. Frank chose to come out ("of the room," as O’Neill memorably mis-announced to his staff) to the Globe with a gruff "Yes, so what?"
Two months later, Frank’s landlady called to tell him the houseboy—Steve Gobie was his name — had been hosting a suspicious number of visitors while he’d been away. It was a prelude to a bombshell: Two years later, Gobie (whom Frank had fired shortly after hearing of his extracurricular activities) went public with their affair in a Washington Times story. In a press conference, the rattled congressman said he had perceived their relationship as something akin to My Fair Lady‘s Henry Higgins and Eliza Doolittle. Gobie’s version was decidedly less sweet: In recounting it later to Penthouse (for which he reportedly earned upward of $40,000), he said he had entertained a number of high-profile clients at Frank’s apartment, and moreover, that Frank had known about it. Though Gobie’s claims lacked evidence, Frank was willing to endure the endless rounds of public introspection in the media required to parse fact from fiction. Another Gobie client, an elementary school principal — who told the Washington Times Gobie reminded him of the son he’d just lost to drugs — resigned. A Republican lobbyist Gobie had serviced committed suicide.
The ensuing ethics investigation concluded in July 1990. Most of Gobie’s stories seemed fabricated, and whatever prostitution may have taken place at Frank’s apartment, it was judged highly doubtful Frank had known about it. But Dannemeyer introduced a resolution to expel Frank anyway, intoning ominously that "the House is on trial today." By that point, though, sympathies were trending Frank’s way. Dannemeyer’s resolution got only 38 votes. Frank, after being reprimanded, was reelected to the House with 66 percent of the vote.
From practically his first day in Congress, Frank was widely considered its smartest member, and possibly its funniest. Though the scandal curtailed his prospects for higher office, it also humanized him, forcing him to articulate the loneliness and emotional underdevelopment that had led him into such a colossally dysfunctional relationship. Having now proven himself eminently fallible, he could — and would — stake out positions that other politicians would shy away from for fear of looking like fools. The truth had set Frank free.
III. The Limits of Foresight in the Face of a Juicy Sex Scandal and Finite Gross National Attention Span
Frank joined the Financial Services Committee during his inaugural term for the typical reasons a freshman Democrat does: It’s big, and therefore not hard to get a seat on, and also oversees affordable housing policy — one of his passions. (The idea that Frank is a liberal housing activist still has wide currency. An investment banker friend who knew I was working on this article told me to tell the "financial antichrist" to "stop hypocritically murdering America.") But the fact is that 12 of the years Frank has spent on the committee have fallen under Republican leadership, which has limited how much housing policymaking he’s been able to do. More beneficially, it’s cleared him to focus his intellect on issues in which he has less of an emotional stake.
One thing Frank’s intellect has had trouble squaring is the insularity of the Federal Reserve. By law, the Fed is granted a much-vaunted independence from politics (that’s why it can change interest rates without a permission slip from the White House or Congress). But during the Clinton years, Frank felt that then-chairman Alan Greenspan had the Fed buying so far into its autonomy that it was in its own sort of closet. It was a point Frank drove home with eerie prescience on what was probably his busiest day as a minority member: October 1, 1998.
On that day, one of Frank’s other committees, the Judiciary, was preparing a series of cases for and against President Clinton’s impeachment over the Monica Lewinsky affair. Like most of his colleagues, Frank felt the proceedings were a joke that cheapened the whole institution. But with his own sex scandal having removed the pieties that bound most Democrats, he was the only one willing to say it, and he had been remaking a name for himself lambasting the process in interviews granted to anyone who asked.
Now the committee was in the final stages of entering into the public record a 4,610-page supplement to the 445-page Starr Report. News cameras clogged the halls of the Rayburn House Office Building as the media camped out, waiting for the documents. The assembled reporters, as they’d learned to do, looked to Frank for good sound bites. But Frank had to tear himself away, because a far more important hearing was in session down the hall. The previous week, the Federal Reserve Bank of New York had intervened to organize a bailout of a huge hedge fund, and Greenspan and New York Fed boss William McDonough were there to explain what had happened.
Long-Term Capital Management was legendary for a trading strategy built on arbitrage algorithms that used historical data on the relationships between the price swings of stocks, bonds, currency, and commodities. The strategy had worked splendidly until earlier that year, when a series of emerging markets crashed, the Russian government defaulted on its debt, and conventional economic logic went haywire. This hardly would have sent the shock waves it did but for two things: To increase its profits, Long-Term Capital traded not only the actual stocks, bonds, etc., but also derivative contracts that bet on the movements of their prices, with each bet having a "counterparty" bank on the other side. And to further amplify returns, Long-Term Capital had loaded up each bet with massive amounts of short-term debt, which meant dozens more creditors. No one knew for sure how much money was at stake if Long-Term Capital blew up. The Fed estimated it could be as high as a trillion dollars, which was why it had been moved to intervene.
At the same time, McDonough and Greenspan maintained coolly that the intervention was really not that big a deal. "Not one penny" of federal funds had been put on the line; it was the affected banks that had chipped in on the bailout. Sure, McDonough and his deputies had provided the conference rooms and "were present" at the negotiations, but McDonough hadn’t, he claimed, actually participated. "This was a private-sector solution," he emphasized, "to a private-sector problem."
Frank laid into McDonough in a way that can only be appreciated in hindsight. He suggested that for all McDonough’s "passivity" in the intervention, he was most likely "in [his] heart of hearts…quite proud" of his hard work averting financial collapse. More important, Frank pointed out that McDonough, while "a very persuasive man," could not have done what he did without the "implicit power" bestowed by the New York Fed — which is to say, a part of government. And from one government employee to another, surely McDonough had to understand how bad it looked when the "mistake-makers" were shielded from huge personal losses by the Fed’s actions.
"A consequence of preventing damage to the system was to leave some of the richest people in this country better off than they would have been if the federal government hadn’t intervened," Frank said. "And that rankles a lot of us…when we’re told we can’t do anything similar for people much needier." The debate over whether the bailout of Long-Term Capital created moral hazard would occupy economists for years to come, but Frank had put forward the real hazard right there: In insisting that the government-brokered deal was private-sector self-healing, McDonough had forgotten that the Fed and Congress were on the same team.
The chain of events threatened by the implosion of Long-Term Capital is almost exactly the scenario playing out a decade later on a massive scale: A single event unpredicted by the models — then the Russian default, today the foreclosure crisis — gets magnified over and over and over again by a financial system loaded up with complex derivative securities. Ten years ago, there were already people in Washington, some Republicans among them, pushing for the monitoring that would prevent that. As early as 1997, the respected Commodity Futures Trading Commission chair Brooksley Born had argued strenuously in favor of regulating the non-exchange-based derivatives that hedge funds were starting to gorge on, only to be shut down by Greenspan and Treasury Secretary Robert Rubin. The Financial Services Committee’s GOP leaders — including its next chairman, Mike Oxley — would pursue their own fruitless reform efforts (which received from the Bush camp what Oxley succinctly described to the Financial Times as a "one-finger salute"). It was all the product of a legislative landscape rife with asymmetries: Republicans with the deepest intellectual interest in finance — and the most information about its excesses—were coming to favor more oversight, but were hamstrung by the larger body’s generalized suspicion of regulation, coupled with the reflexive bias against it of the Bush administration and the Fed, which also happened to harbor a reflexive disdain for Congress.
During the October 1, 1998, hearing, Frank would have no success in his efforts to rewire that dynamic. "I understand there are those who believe that while democracy is capable of dealing with many, many issues, it really cannot be trusted with matters of high financial policy," he half-joked to Greenspan and McDonough at one point. "There is an overwhelming tendency, when you come here, to speak to us as if we were adolescents who need to be told some things but who are not ready for the entire truth." Of course, with the rest of the House consumed with fashioning thousands of pages of documents into a case to impeach the president over a blowjob, treating people like adults was clearly not at that moment Washington’s, or the media’s, or the country’s, highest priority.
A moment from the 1998 Clinton impeachment proceedings among, from left, Representatives Henry Hyde and John Conyers, an unidentified aide, and Frank.
IV. The Fungibility of Zero-Risk Bets and $55 Trillion FUBARs
Barney Frank now says his biggest blind spot was his limited understanding of the unregulated derivatives that Brooksley Born had been warning the Financial Services Committee about, and the extent to which they intensified the risk of subprime loans and spread it out through the international financial system. From an academic perspective, that’s true. Policy-wise, his more fundamental blind spot was the reason he joined the Financial Services Committee in the first place: his interest in housing, and specifically the federally sponsored mortgage giants Fannie Mae and Freddie Mac.
Fannie Mae was founded by the government in the 1930s to encourage homeownership by lending money to banks so they could extend mortgages to middle- and working-class borrowers. In 1968 it was privatized in a ploy to balance the federal budget that "saved" the government billions by getting the mortgages off its books. No one then believed the government would not guarantee the mortgages it bought; no one ever would. If Fannie Mae ran into cash-flow problems, a federal bailout seemed assured. As Michael Lewis wrote in Liar’s Poker, his definitive book on the advent of mortgage bonds, "To stand up in Congress and speak against homeownership would have been as politically astute as to campaign against motherhood." Or economic growth.
And here we return to Alan Greenspan. Where previous Fed chairmen had focused mostly on reining in inflation, Greenspan gave himself a dual mandate: He’d keep inflation in check while also growing the economy, something he did by holding down interest rates and applying a rather malleable definition to price stability. Fannie Mae, too, had a dual mandate: to help middle- and working-class families buy homes while also making fat profits for shareholders — a toxic combination.
Frank was actually an early skeptic of the rapid growth of homeownership, especially against the backdrop of a fast-widening income gap. But he abided it, and supported Fannie Mae and Freddie Mac over the years because they were the only vehicles he had for affecting housing policy under Republican rule. Then, in 2003, the Bush administration began to mobilize to toughen regulations on Fannie and Freddie in response to a host of accounting shenanigans (shenanigans that came during a stretch that had also seen the collapse of Enron, as well as sundry other big corporate scams). Frank was among the Democrats — who, not for nothing, took thousands in campaign contributions from Fannie and Freddie — seeing the White House’s move as basically a power grab that would have robbed the committee of what they considered their last shred of authority over housing policy.
Frank’s argument, essentially, was that the Bush administration was ginning up accounting irregularities as an excuse to undermine the American Dream. "The more people exaggerate these problems," he said during one of the hearings that ensued, "the more pressure there is on these companies, the less we will see in terms of affordable housing."
What critics who’ve used that sentiment as their basis for blaming Frank for the whole home-loan meltdown fail to acknowledge is that once passions cooled, Oxley and Frank marshaled support for a bipartisan bill regulating the mortgage giants that passed 331 to 90, only to be ignored by the White House. Further, the worst abuses at Fannie and Freddie, and in the larger mortgage business, did not begin until 2004, the year the credit-rating agencies lowered their standards for mortgage-backed securities. At the same time, the SEC relaxed capital requirements on investment banks, allowing them to take on 20 and 30 times their total assets in debt, which just accelerated the chase around the financial world for new bets to make.
Ultimately, there were only so many of those bets to place. And the shrewdest one, that it would all go bust, was also a tricky one to pull off. It’s relatively easy to short-sell a stock whose price you think is going to fall. But betting against the housing market requires an esoteric type of derivative security called a credit-default swap, an area of finance Frank had been putting off figuring out. ("Derivatives also is something we have to look into," he said during a 2003 hearing. "I say that with all the enthusiasm of being told that we’ve got to go back to trigonometry and take a test in it.")
Perhaps as penance, Frank now explains credit-default swaps (cwredit-defawlt swaaahps, when he says it) everywhere he goes. One Saturday morning a few weeks before Election Day, he arrives early to an otherwise deserted Sturbridge hotel for an annual gathering of state selectmen and launches into his lesson just before 9 a.m. He begins with a topic arcane to most, but familiar to anyone in local government: "monolines."
When a city or town decides to float a bond offering to pay for a stadium or an airport renovation or some such, it can usually borrow at lower rates if it buys default insurance from a bank — the monoline — which insures the principal in case of default. Well, credit-default swaps are just like bond insurance, except you don’t need to be an insurance company to sell them, and you don’t need to own any actual bonds to buy them. If you were selling swaps, you could issue infinite insurance policies on the same bond; if you were buying, you could purchase limitless amounts.
The prices charged for swaps were generally based on the historical rate of default for the underlying variety of bond, and mortgage bonds, throughout most of the relevant history, had rarely defaulted. Accordingly, swaps based on mortgage bonds could be had on the cheap, though acquiring them looked like a sucker’s move: It meant taking the very contrarian position that home values were due for a big fall. "They thought they were selling life insurance to vampires!" Frank says. By the time it became clear that housing prices would indeed not hold, the dollar amount pegged to or hedged by credit-default swaps had reached $55 trillion.
In other words, per Frank: "These people insured so much money…that they now owe more money…than there is money!"
It’s a line he’ll repeat over and over, always to roars of laughter, because if you can’t laugh at financial Armageddon, what can you laugh at? But underlying it is a question that’s not so funny: What if someone had told every man, woman, and undocumented worker who signed up for a mortgage after 2005 that the smartest money on Wall Street was betting trillions of dollars that they’d wind up in foreclosure?
Who knows, maybe the market would have worked. And maybe Barney Frank wouldn’t be diving headfirst into the moral-hazard morass that is coming to the rescue of a bunch of guys who vilify him as a left-wing zealot. As it is, as he told the crowd back at that New Hampshire fundraiser, "I’m from the government, and I’m here to help. That used to be a right-wing joke!"
Source URL: http://www.bostonmagazine.com/2008/11/a-crash-course-in-crisis-economics/