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Tuesday, September 16, 2008

Lehman Brothers and the Free Market

What if I told you that there is a segment of real estate that is booming right now? I bet you would tell me I was crazy. You would be wrong. If you buy, sell, or market foreclosed properties, business is very good for you. Furthermore, since it is difficult to qualify for a loan, there are more renters. As such, if you are a landlord business is also better for you. Furthermore, the shock to the market has sent interest rates way down. As such, if you are an excellent borrower and you've made your payments on time, this financial crisis may very well reward you with better loan terms. That is the nature of these so called crises. For every loser, there is someone on the other side that is the big winner. Lot's of people lost big on October 29th, 1929, however a few smart folks won big when they invested on October 30th, 1929. In many ways markets can be a zero sum game, not always but it can. For every boneheaded move that is punished there is an equally astute move that is rewarded.

In the same manner, much the same is happening in the aftermath of the collapse of Lehman Brothers, Merrill Lynch, and AIG. All three made foolish gambles and they are paying for it. Bank of America, on the other hand, has swooped in a shrewd and heartless manner and picked up the pieces of Merrill Lynch at a significantly reduced rate. That's what happens in any capitalistic market. Stupidity is punished and shrewdness rewarded. That's why I am troubled that the politicians on both sides are proclaiming the system broken. Far from it, the system is performing exactly as it was designed to perform.

The silly calls from both sides of the aisle today are cynical at best and downright naive at worst. Both sides are calling for reform, transparency, and accountability. Last I checked having to file for bankruptcy is being held accountable. Those politicians that complain that we don't have enough transparency are themselves being totally misleading. It wasn't that these transactions weren't transparent. Rather that these financial vehicles are the financial world's equivalent of rocket science. It doesn't much matter how transparent the transaction is if no one outside the investment bankers that put it together have any idea what any of it means. Yet, the familiar call of reform is uttered each and everytime the markets are shaken, as though capitalism and markets have ever guaranteed that there will never be financial stress.

I, myself, can save all the politicians months of analysis and I will tell them exactly why Merrill Lynch, AIG, and Lehman are in such trouble. It is because of greed, recklessness, stupidity and carelessness. Unfortunately, there is no government regulation that can guard against those human failings. You can't unfortunately regulate stupidity. As the GEICO commercial goes, I do have good news. There is in fact a force that can regulate and punish all those human failings and that force is the market itself. That's exactly what the market did with its swift hammer when it forced Lehman into bankruptcy and Merrill Lynch into accepting a very unfavorable buy out offer. Just as quickly as it punished their irresponsible behavior it rewarded the shrewd behavior of Bank of America as they bought out Merrill Lynch at a favorable rate.

The same dynamic would have taken place if the politicians had stayed away from trying to fix things when the mortgage crisis hit. For every borrower that would have been foreclosed on there would have been a shrewd shark on the other side buying that very property at a reduced price. Once again, the market would have punished irresponsible behavior and rewarded shrewd behavior. Of course, there is no political capital in supporting the behavior of the vultures that swoop in to buy foreclosed properties and so the politicians couldn't simply stand by and let the market dynamics punish those that deserved punishment reward those that deserved reward. Instead, they stepped in and offered a lifeline to borrowers that deserved no such thing. Instead, borrowers who became late on their mortgages will now be rewarded with mortgages they would never get in the open market. Meantime, borrowers that are on time are stuck with the same mortgages they had. Furthermore, banks stuck with mortgages they couldn't sell themselves in the open market will be able to sell them to the federal government at inflated values.

This is the sort of "reform" we can look forward to if either side actually follows through on some of these same campaign promises. For instance, both sides have already taken to attacking an easy target, CEO's of failed banks. Both sides are promising to end the practice of fat CEO bonuses for CEO's that preside over failure. Now, I am no less appalled at the likes of Angelo Mozillo getting tens of millions while Countrywide failed than anyone else. That said, exactly how will the federal government insure that CEO's don't walk away with millions while the company fails? Will the Congress create a committee to examine all CEO packages? Will the Congress create a committee to approve all CEO bonuses? While I agree that it is obscene to allow CEO's to make millions while companies fail, isn't that ultimately the discretion of the board not the government?

All reforms come with unintended consequences. For instance, to manage future risk the feds could once again limit the finanical activities that banks can engage in. That would mean that banks that hold your checking account wouldn't also be allowed to hold your mortgage or your investments. Of course, if you feel comfortable handling all your financial transactions at one place, the government would make sure that is no longer an option. Frankly, what sort of "accountability" can the federal government provide that a bankruptcy and a defensive merger didn't provide? Wasn't it the market itself that held bad borrowers, irresponsible banks, and irresponsible financial services companies accountable for their actions? Will the Federal Government now sit in on merger and acquisitions meetings and approve all financial mergers?

That's the nature of the market. Industries evolve and adapt. Companies need to evolve and adapt with them. Companies that fail go away, and companies that perform shrewdly thrive. We no longer have the likes of RCA, Texas Instruments, Commodore, or the blacksmith, however I don't remember anyone demanding accoutability, transparency and reform when those institutions failed. Just because some financial services companies have failed doesn't mean the industry will. The industry will not only survive this but live to see the day when it will thrive through this, unless that is if the government follows through on their insistence for accountability, transparency, and reform. Then, it is just very possible that the government will insure that financial services will be impossible to conduct.

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