Seeing Shades of the 1930s

When the 1990s telecom/dotcom bubble burst, official Washington responded with a yawn. But the housing/subprime/ credit mess has inspired a different reaction for two important reasons: leverage and connectivity. Bear Stearns had more than $30 of debt for every dollar of capital. And U.S. banks are connected at the umbilical cord to institutions around the world. "The actions on Bear Stearns were necessary because Bear Stearns was extensively interconnected with the rest of the global financial system," says former Clinton Treasury secretary Robert Rubin. That holds doubly true for Fannie Mae and Freddie Mac, whose securities are bought in bulk by central banks around the world. The use of complex financial instruments like derivatives and credit default swaps have bound institutions the world over together in a contractual tower of cards that can easily collapse.

This time around—as was the case in the 1930s—the problems arose in unregulated or lightly regulated sectors. Subprime lenders (many of which were not part of the FDIC system) sold loans to Wall Street investment banks (which are not regulated by the Federal Reserve), which in turn traded them with unregulated hedge funds. As a result, there were few early warnings and no established protocols for dealing with a failing institution. The result: regulators have had to act like John Coltrane and Oscar Peterson. They're improvising.

The jam session started in March, when Paulson and Bernanke worked out a deal for JP Morgan Chase to take over ailing Bear Stearns. Paulson helped dictate the price, and Bernanke agreed to let JP Morgan present $30 billion in assets belonging to Bear at the so-called discount window—usually available only to banks in the system—in exchange for cash. In the ensuing weeks, as Wall Street firms were leery about lending money to one another, the Fed opened up the discount window to 19 investment banks—which, like Bear, aren't regulated by the Fed—thus putting more taxpayer funds at risk. As of last week, $13 billion in such loans were still outstanding.

Those sums pale in comparison to the potential exposure proposed last week, when Paulson and Bernanke gamely asked Congress to have the taxpayer explicitly back the $5.2 trillion in combined debt of Fannie Mae and Freddie Mac. "It's an unprecedented request for an open-ended amount," said Rep. Spencer Bachus, a House Finance Committee member and one of a group of skeptical GOP congressmen who met with Paulson after the hearing last Tuesday. Lawmakers said they want a quo for all the taxpayers' quid they're putting in.

One key difference between the current relationship between Washington and Wall Street and that of the early 1930s has to do with the political standing of the financial industry. Despite the recent disasters, the bipartisan revolving door from Wall Street to Washington—both the Clinton and the Bush administrations had Treasury secretaries who ran Goldman Sachs—is still whirling. Fannie and Freddie have a long history of hiring politically connected executives and lobbying intensely. Wall Street remains a vital source of campaign funds for Democrats and Republicans. "FDR talked about throwing the money changers out of the temple," says author Kevin Phillips, whose best-selling "Bad Money" describes the ascendance of finance in politics and the economy. "These guys [today] talk about keeping the money changers running the temple and charging 28 percent on credit-card interest." James Grant, proprietor of Grant's Interest Rate Observer, and one of the few on Wall Street to warn about the credit crisis, said that given Wall Street's failures, there should be a bipartisan hue and cry to insulate taxpayers from bankers' failures. "But I hear neither of the presidential candidates saying anything like that," he said. "The political dog that didn't bark is the one that is watching Wall Street, but it is fast asleep."

With Daniel Stone

© 2008