The End of Illusion, Part Two

Rich Lowry

9/18/2008 7:29:39 PM - Rich Lowry

The Bush years will be remembered for the cruel triumph of realism over illusion.

One of the era's great illusions was spun by President Bush -- that the force of freedom was so irresistible, it would prevail in a place like Iraq even in the absence of law and order. Bush himself eventually realized his mistake. The second illusion -- fed by anyone who possibly could get rich from it -- is bursting now.

Wall Street is experiencing one of its most wrenching periods since traders began gathering around a tree there in the 1790s, beset by a terrible reckoning: No, interest rates can't be held at unsustainably low rates -- 1 percent in 2003 -- without stoking wasteful investments; no, housing prices won't always go up; no, home loans can't be extended to people with shaky credit histories on scandalously easy terms (no money down!) with the expectation that they'll be paid back; no, fancy financial instruments and computer models can't eliminate risk; no, firms can't exist on massive debt -- now-bankrupt Lehman Brothers had debts 35 times its capital -- without courting disaster.

It's a sign of how fragile the entire financial edifice had become that a decline in housing prices of about 20 percent could precipitate the current near-meltdown. It's easy to blame greed, as John McCain is doing at every opportunity, since it's a given. Greed is endemic to the human condition, even if it is most visible on Wall Street. Lehman Brothers CEO Dick Fuld made $22 million last year, leading his firm toward the abyss, while Wall Street doled out $23.9 billion in bonuses in 2006. But everyone else joined in the wide-ranging bonanza.

As financial guru Ric Edelman writes, "The insurers got rich selling policies with fat premiums, brokerages got rich selling new securities, lenders got rich selling more loans than ever, builders, real estate agents, title settlement companies, appraisers, inspectors -- everyone got rich from the ensuing real estate boom."

He could have included the politicians who enabled the irresponsible lending of Fannie Mae and Freddie Mac because they knew these "government-sponsored enterprises" -- since bailed out by the government at a potential cost of $200 billion to taxpayers -- would line their campaign coffers. Fannie and Freddie were the "patient zero" of the financial contagion, encouraging and blessing the "subprime" loans that were a toxin spread throughout the financial system. Many Republicans, including McCain, wanted Fannie and Freddie reformed. As a largely Democratic cash cow, it was protected by Democrats, enamored of its mission of extending homeownership to those who -- it turns out -- couldn't afford homes.

With the financial system teetering on collapse, the federal government has become the backstop. "Raw capitalism is dead," Treasury Secretary Hank Paulson has said. With Paulson and Fed Chairman Ben Bernanke deciding case by case which companies the federal government will save or not, he's not kidding. After letting Lehman die, they essentially took over $1 trillion insurance giant AIG, making the taxpayers instant stakeholders in its far-flung businesses from life insurance to aircraft leasing and a ski resort.

In this environment, it's hard to resist calls for more regulation. But it has to be intelligent and measured, an extremely difficult task when the market is constantly adapting and the next excess will come in a new form. A basically solvent company, AIG was rendered illiquid by so-called mark-to-market accounting rules that say assets must be marked down to their value in the current market, even if they are ultimately worth more. This was a reform adopted in response to the Enron scandal that has worsened the current crisis.

Winston Churchill famously said that democracy is the worst system except all the others. The same could be said of capitalism. There is no way to eliminate all the human failings -- greed, exuberance, shortsightedness, fear and ignorance -- that created the predicates of this crisis and are fueling it now. If we pretend there is, we only foster another illusion.