Heads I Win, Tails You Lose, Part 2: The Fox in the Henhouse

Then we had one major phone company, A T & T. Ma Bell was broken up into many companies. Although mandated by court action the outcome was in the spirit of creating more competition, a central goal of deregulation. This happened during a time of revolutionary technology advances in communications. Phone costs went down and great wealth was created during this period yet we have seen consolidation of the various spin offs and soon may see only a very few phone companies. While deregulation provided investment opportunity it also established confusion regarding implementation of standard protocols to maximize the benefits of the new technology. Our cell phone system lags far behind Europe and even many third world countries that have implemented very efficient systems.

Air travel used to be highly regulated. Deregulation opened competition and we saw airfares go down. We also now have no major airline that is in a strong financial position. Air travel used to be a delight, a welcome treat from the long car ride (or even earlier the long train ride). Air travel today is a nightmare. While much of this is due to the necessary security required security has little to do with the smaller seats, fewer amenities and surly service.

During this period deregulation has been perhaps most prominent in financial markets. Deregulation has encouraged the creation of new products and markets to manage them. At the same time restrictions to world trade have been removed providing the opportunity for economic revival in India, China and other under developed nations. It also made Wal-Mart the largest employer in the world as consumers all over the world lined up to buy all the cheap goodies made in this deregulated environment.

Like any living organism markets require fuel to survive. Business is fueled by credit. Deregulation removed restrictions to the movement of credit. Lenders were no longer required to maintain the reserves once mandated. Borrowers were scrutinized less closely in order to grease the wheels of this great credit machine. Huge amounts of capital were brought to the market as the new manufacturing giants, China, Japan and India looked for ways to invest the gigantic flows of cash coming into their economies.

A credit collapse can be viewed in a simple manner as a great game of musical chairs. As more kids came to play more chairs were put out. Some chairs were sturdy and some chairs probably couldn't hold the smallest tot, but it looked like a chair so everybody was happy with the game. Whenever the music stopped there were always extra chairs for everyone.

Then property values, which provided the underlying collateral for many of these credit securities (chairs) decided to change the rules and not conveniently continue to increase. Over valued homes flooded the market sending prices into a tailspin and there were no borrowers (buyers) because the lenders could not lend into a falling market. Now when the music stopped there were fewer chairs sometimes many fewer chairs since the players in the game had leveraged their investment sometimes up to 100 to 1. That means for each dollar you had you would borrow $100 and invest $101. Every time the market went up 1% you doubled your money. That's a good way for a CEO to guarantee a compensation package of tens or even hundreds of millions of dollars.

Unfortunately as the market dropped all of the meager equity invested by the greedy players went to investment heaven and all they had left were the huge debts. Everyone tried to head for the exit, or in our analogy grab a chair, but the exits were barred and the chairs were disappearing at a geometric rate. The only anchor was the value of the underlying real estate but since no one knew how low the value would go no one could price the securities and no one was willing to make a market in them. Just like the old saying about the sound of a tree falling if no one is there to hear it, what is the value of a security if no one is willing to make an offer to buy it?

That brings us to our current dilemma. Credit markets are in a free fall. Lenders are afraid to make loans at any price. When credit dries up the economy stagnates and we enter a recession. It the halt is strong and reaches across world economies we could enter a depression. That's why Treasury Secretary Paulson and Fed Chairman Bernanke have requested extraordinary powers be given to the Treasury. It is basically a blank check from the American taxpayer for the Treasury Secretary to buy the unwanted credit securities. This it is hoped will provide a foundation for other financial organizations to continue to de-lever (raise equity by selling assets, the opposite of leverage which is to increase debt) and calm a panicky credit market.

The problem is that the Treasury is not in this business and in order to accomplish this task they will need help. Umm, who has experience dealing with complex credit swaps and complicated third-party collateralization? Hey, it's the same people who got us in the mess in the first place. Let's bail them out by buying their securities and then hire them to sell them off. Lets hire the fox to guard the henhouse. The result could well be that the taxpayer will absorb all of the loss and others will benefit from any residual value in these securities.

Bad idea. The central defect of deregulation has been that it privatized profit but socializes loss. This creates the situation of moral hazard that is defined as the lack of any incentive to guard against a risk when you are protected against it (as by insurance). Although huge profits have been generated by deregulation most of these profits have accrued to shareholders and corporate executives. Income inequality has increased in this country to levels we have not seen since the late 19th century, when there were no regulations to deregulate.

While the rich have gotten richer on several occasions when speculative markets have bubbled and then burst it has been the taxpayer who has been called upon to bail out the failed investments. This is not a viable economic arrangement, as it will inevitably continue until there are enough disincentives in the form of exposure to risk, for the investors to moderate their behavior. Greed is balanced by fear and if you take away any fear of the consequences for the outcomes the pathological behavior will continue.

There is good reason for the government to intercede when society is in peril. That's why we have our socialized fire departments, police departments and state and federal armed forces. The current credit crisis requires such intervention but not by throwing gas on the fire in the form of empowering the very rogues who raked in unimaginable profits during the good years and now want us to not only bail them out, but also pay them for bailing themselves out.

A more reasonable model is seen in what we have done with AIG. We lent them money they required for liquidly and have warrants to buy up to 80% of the company at a very reasonable price. We help them and if it works out we make a profit. Current AIG shareholders lose but that's the risk they took. That's the way it is supposed to work. You take the risk you reap the rewards or you suffer the consequences.

Here's a proposal. First lets take a break from the panic by putting a moratorium on all foreclosures for the next six months to a year. This will take the pressure off many distressed homeowners and give us some time to think this through. Its not a long-term solution but it gives everyone some breathing room. I would also go the FPA, the Financial Planning Association, and ask their members to volunteer to give credit counseling, at no cost, to these homeowners in order to see if there are ways to work out of the problem on an individual basis. I would sign up to provide this service and I know thousands of my peers would so as well.

Lets determine what financial companies are worthy of our investment and offer them the same deal we made with AIG. Hank Paulson is the last guy you would want negotiating this deal. He is the former Chairman of Goldman, Sachs and one of the bandits who raked in the oodles of cash during the good years. He has far too many conflicts of interest.

If the government hired me as their financial planner for this problem I would suggest that they think like an investor. Who would I want managing my investments at a time like this? How about the greatest investor of modern times, Warren Buffet? He has already invested $5 billion in Goldman, Sachs. Lets pay him a fee to manage our taxpayer's investment in other troubled companies. If he thinks they are a good investment we invest. If not they go to investment heaven, or hell. As for inspiring confidence, who could we select for this job who would give more comfort to shaky markets?

We are hearing a lot of dire forecasts from the administration designed to instill fear and coerce Congress into making a hasty decision. We made this mistake with the rush to war and the Patriot Act. Both were made under fear and duress. We now have cause to regret both. We need to carefully look at this bailout proposal and determine what is really in the interest of American taxpayers and what is in the interest of troubled Wall Street firms.

If I were President Bush I would be on the phone to Mr. Buffet, today.

President Bush: "Hey Buffy, how,ya doin?"

Warren Buffet: "Very well Mr. President. I always love an opportunity for a good investment."

President Bush: "You think the American taxpayer could get in on that? We really need you Buffy"

Warren Buffet. "I would consider it my duty as an American to serve"

President Bush: "Great! Say Buffy I'm going to be out of a job soon. Any chance I could get in on this action?"

Warren Buffet. "Unprintable response"

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