Yesterday at 3 p.m., these were the top headlines running on Bloomberg's news service:
· Stocks in U.S. Drop Most Since 2003.
· Treasury Yields Decline to Lowest Since December.
· Orders for Durable Goods in U.S. Tumble 7.8 Percent.
· Freddie Mac Will Tighten Standards on Its Purchases of Subprime Mortgages.
· Yen Advances as Investors Unwind Bets on a Drop in the Japanese Currency.
· Residential Real Estate Loan Delinquencies Reach Four-Year High, Fed Says.
And finally, my personal favorite:
· Texas Pacific's Bonderman Predicts Another Record Year for Buyout Firms.
It's all one story, folks. Years of dirt-cheap debt have spawned bubbles across a wide range of asset classes, from U.S. home mortgages and commercial real estate to Chinese stocks to Indian office buildings. It's been a wonderful ride for the U.S. and global economies, and particularly for Wall Street financiers. And sooner or later it had to end.
It's not possible to know yet whether this is the beginning of that unwinding process. If history is any guide, markets today are as likely as not to bounce back strongly as some big players decide this is a "buying opportunity." But whatever happens, we now have a good indication of exactly how the Japan "carry trade" and "credit-derivative swaps" and the default rates on subprime mortgages are all related -- and how they all relate to sales of Coach handbags.
No doubt they were burning the midnight oil at the Treasury and the Federal Reserve, and burning the phone lines to Beijing, Tokyo and London to ensure that this doesn't turn into a global meltdown.
At this point, it's a confidence game that has little to do with the underlying economic fundamentals, which obviously didn't change that much between Monday night and Tuesday afternoon. In the past couple of weeks, the financial press has been full of stories acknowledging how nervous people were in financial markets about the high prices for certain assets, how narrow the spreads had become between the interest rates on supposedly risky investments and U.S. Treasury bonds, the deterioration of credit quality, and the degree of leverage (debt) in the financial system. And it is at that moment that things get dangerous -- when just about any piece of bad news can start a stampede toward the exits, when unvarnished greed gives way to unadulterated fear.
And make no mistake: This is herd behavior, as irrational on the way down as it was on the way up.
It was a bit of bad luck that yesterday was the day Robert Steel, the undersecretary of the Treasury for domestic finance, chose to lay out the Bush administration's case that the best protection against a market meltdown -- "systemic risk," as it is politely called in policy circles -- is not more regulation, but allowing markets to discipline themselves.
"Sophisticated financial firms have both the direct financial incentives and expertise to provide for effective market discipline," Steel told regulators and financial industry executives gathered in the Treasury's majestic Cash Room. "We believe that the collective decisions of self-interested and informed counterparties, reviewed by regulators, provide the very best protection against financial risk." Steel's goal was to head off calls for direct regulation of the hedge and private-equity funds that have come to dominate financial markets.
Steel's model is a fetching one. Banks deciding on their own to upgrade their "risk-management systems" to make sure that they do not have too much exposure to any one borrower or asset class or trading strategy. Pension funds and other institutions stepping up their due diligence before making investments, and insisting that hedge and private-equity funds provide them with background checks on fund managers and more timely information about strategies and performance. Funds themselves changing their cowboy trading cultures to embrace rules and procedures and reporting requirements that will prevent anyone from taking on undue or unauthorized risks.
It's a lovely theory, but it doesn't square very well with recent history -- the junk bond craze of the late '80s, the commercial real estate bubble of the early '90s, the Asian financial boom and the tech and telecom bubbles of the late '90s. For it is at times like these, when markets are at their most frothy and in need of discipline, that lenders and investors and the highflying fund managers tend to get the sloppiest.
This is when mortgage bankers, having already refinanced every house in America at least twice, start making home loans to people with poor credit histories requiring little or no money down and an option to skip monthly payments whenever they are short on cash, as they did in 2005 and 2006.
It is at these times that banks, eager to continue delivering double-digit earnings growth, compete furiously to finance mergers and acquisitions, allowing borrowers to put less of their own money into deals and forgoing the usual conditions that would allow the loan to be called if business begins to sour. In many cases, they are even putting their own equity into the deal.
And now is when pension funds and college endowments that have held back from investing in hedge or private-equity funds finally decide to jump on the bandwagon -- hardly the time to expect them to make demands about greater transparency or internal controls.
In other words, this is precisely when markets need good regulators, and good regulations, to make these financial intermediaries behave in the "rational" way that the Bush administration says they are supposed to. To leave it to "voluntary" codes of conduct and "market discipline" is both naive and dangerous.
To be fair, the Bush administration is moving belatedly to significantly step up surveillance of bank lending. The comptroller of the currency has issued tougher guidelines on mortgage and commercial real estate lending, and now has in his sights the loosey-goosey "leveraged loans" that have been used to finance corporate buyouts.
And under the aggressive leadership of Tim Geithner, the president of the Federal Reserve Bank of New York, the Fed is requiring the big money-center banks to upgrade their risk-management systems and subject their portfolios to "stress tests" to see if they would withstand a financial crisis in which credit dries up and everyone tries to unwind their positions at the same time.
Unregulated and highly competitive financial markets are wonderful at lots of things -- allocating capital efficiently, coming up with innovative products, pricing and spreading risk. But, as we were reminded yesterday, one thing they are not good at is controlling their own excesses.