January 28, 2008

Watching the Market Evolve

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The weakened economy is now playing center stage. The subprime mortgage meltdown has everybody up in arms against the greed of corporate America. The fact of the matter is that while it is a serious problem and people are losing their homes, this cannot deter financial risk-taking and innovation. Yes, some people were hurt and they need to be helped. Furthermore, there needs to be some assurance that this will not happen again. However, Americans and those running for president (cough…Hillary Clinton…cough) should not jump the gun and assume that all of Wall Street and the financial industry are corrupt.
Many factors contributed to the problems that we now face within subprime mortgage market. Among them are the low-fed funds rate of the early 2000s, the subsequent housing bubble, creative investment tools, risk-taking and greed. Yet the only story that seems to be coming through the media is that of greed. It is very easy for the story to be spun in to “The Barons of Wall Street Prey on Poor.” It is more difficult for the story to be portrayed as an innovative financial system that has hit a bump in the road. Calculated risk-taking has made the American economy the most powerful in the world. Yes, we are probably entering a slowdown, but much of the negativity that has been expressed is largely unfounded.
The reason the U.S. economy has been so resilient is the innovative financial devices that have emerged in recent years. Hedge funds, private equity groups and institutional investors all get a bad rap, especially for their respective roles in the subprime problem. The CDO’s and SIV’s that were established in order to spread the risk involved with subprime lending backfired. The artificially low rates that were initially offered skyrocketed as soon as home prices failed to rise and now millions face foreclosure. Yet, the principle behind the risky lending was what has propelled our economy. Capital gains have consistently been high and the hedge funds that are consistently demonized not only provide liquidity, but they enable investors to take on substantial and calculated risks with the prospect of high reward. In turn, many Americans, whether it is through the purchase and sale of stock, dividends, or simply working for a company that has reaped the benefits of innovative financial tools, has benefited from our financial system. It is easy to blame the powerful and this is nothing new. Rockefeller and J.P. Morgan were ridiculed in their day. Nonetheless, America is built on risk-taking and we should not lose sight of it.
This principle of risk-taking and allowing the market to sort itself out seems to be lost on some Democrats, namely Hillary Clinton. I will concede that if there needs to be government oversight, and there needs to be assistance offered to the victims of the subprime meltdown. I will also concede that the other Democratic contenders for the presidency are no friendlier to corporate America than Mrs. Clinton. However, upon reading the New York Times headline, “For Clinton, Government as Economic Prod” and then reading that Clinton was quoted as saying we need a “vigorous government” with respect to the economy, I was frightened. Maybe she does not remember that the government needed to be bailed out by J.P. Morgan during the Panic of 1893, or that Nixon’s price controls (similar to Clinton’s interest rate freeze plan) backfired. The crux of the matter is that usually the market will work itself out without extensive government intervention. The companies that engaged in risky subprime lending are now getting hurt. They are downsizing, engaging in write-downs, losing profits and losing investors on a seemingly daily basis.
Probably the most important point to be made here is that the losses that companies are currently incurring will deter them from similar risky behavior in the future. In addition, private counterparty surveillance is as equally strong a regulation mechanism as is the government. Investors no longer trust credit ratings and banks do not have faith in bond and mortgage insurers. These natural outcomes of the subprime mortgage meltdown will ensure that this will not happen again. The likes of Hillary Clinton should not be condemning the U.S. financial system. Rather, there should be help offered to those in need, no more and no less. That is the only way to make sure that our financial system evolves.

Lee Blum is a Sun blogger. He can be reached at [email protected].