The truth about the great financial meltdown: Round 2

July 6, 2012

My last column, looking at five myths and misconceptions that have emerged since the financial crisis first surfaced five years ago, clearly hit a nerve. It elicited more than 500 online comments, an unusually large response. Most commenters were critical of what I wrote, which is par for the course.

The major criticism, as I determined with assistance from my colleague Omar Akhtar — between us, we actually read all the comments — was of my first point: that having the government do nothing was not a realistic option. Dozens of commenters said that cleaning up the mess should have been left to the private markets, which would have done things better than the Federal Reserve, Treasury and the rest of the government did.

What most of those people probably don’t realize, though, and what I had no room to discuss in my last column, is that private markets took the first big swing at recapitalizing troubled financial institutions — and struck out.

By my count, eight capital-needy American companies — Citigroup, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, Morgan Stanley, Wachovia and Washington Mutual — raised a total of $93 billion from investors from late 2007 to July 2008. That’s a lot of money. Much of it came from some of the best, brightest and richest investors in the world, ranging from TPG Capital (WaMu) to Davis Selected Advisors (Merrill) to sovereign wealth funds from Kuwait and Abu Dhabi (Citi). The full list is on fortune.com/sloan.

Oops. Those savvy, deep-pocketed investors sustained staggering losses in the blink of an eye, as the world’s financial problems rapidly worsened. After that, without government backing there wasn’t going to be much private capital for troubled institutions. That’s why Uncle Sam had to step in.

The alternate complaint — that the government should have nationalized troubled institutions — sounds plausible, too. But that strategy stood no chance of working, regardless of how things played out in other countries. First, seizure would have resulted in endless litigation. Second, there were practical problems. For example, when I looked into the consequences of the government nationalizing Citi, I discovered (from independent third parties) that Citi most likely would have had to surrender lucrative franchises in several foreign countries that don’t allow banks there to be owned by foreign governments.

The other widespread criticism was of my last point: that although the government lowered some mortgage loan standards, the debacle is primarily the private sector’s fault. I was attacking the oh-so-convenient myth that private markets are blameless and pure, that the whole problem comes from misguided government efforts to help “those people” get homes they couldn’t afford. Many commenters were, shall we say, displeased.

Well, let’s see. Most of the bad mortgages were made to supposedly qualified borrowers, without pressure from the government. Lenders required little in the way of down payments or credit checks; they wanted to juice up their loan volume. Credit-rating agencies gave AAA ratings to trash, to keep fee income flowing. Yield-hungry investors snapped up garbage that bore the agencies’ imprimatur. Private enterprise all the way.

Credit default swaps and other esoterica spread the problems worldwide, magnified losses and put even the soundest institutions at risk. That’s because if giant, less sound institutions had failed
en masse, they would have defaulted on their obligations to their sounder trading partners.

We also need to remember that for all the criticism (including mine) of particular tactics, Henry Paulson Jr., Timothy F. Geithner and Ben S. Bernanke bailed out the U.S. financial system at no net expense to America’s taxpayers. An impressive achievement.

Instead of a discussion about what happened, we’ve gotten into a government-vs.-free-market shoutfest. These fragmented days, many people tend to see things in black-and-white terms, in ways that reinforce what they want to believe. The real world is more complicated than that. Black and white have their places — but to understand the financial meltdown, you need to see some gray. 

Sloan is Fortune magazine’s senior editor at large. To read his previous columns, go to postbusiness.com.

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