How Capitalism Died in 2008

01/22/2009 1:00 pm EST

Focus: MARKETS

Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Richard Lehmann, editor of the Forbes/Lehmann Income Securities Investor, traces the roots of the financial crisis to the technology boom of the 1990s.

Capitalism as we know it died in 2008. The “invisible hand” identified by Adam Smith as the driving force behind capitalism has been replaced by the “helping hand” of big government.

How did this happen?

Once upon a recent time, there was prosperity in the land and steady growth was the order of the day. But trouble was on the horizon, by the name of Y2K. This trouble predicted that computer systems would collapse on January 1, 2000 because they had not been designed to accommodate a change in the century.

[So,] a massive effort was launched to correct for this problem, [involving] an entire upgrade embracing the newest technologies. This multiyear effort compressed expenditures into a two- to three-year time period. The economic effect was tremendously stimulative, especially in the stock market, where the prices of technology companies which benefited from all this spending surged.

In addition, the solons at the Federal Reserve had pumped liquidity into the financial system in anticipation of Y2K problems and now had to soak it up or risk inflation. The result: a stock market meltdown of massive proportions.

But the [expectation] of 20%-a-year investment return did not go away, [even though] a post-Y2K economy no longer had the ability to stimulate stock prices at 20% a year. Other ways had to be found to make this happen.

A whole cadre of new players brought huge amounts of capital to the game—highly leveraged capital to boot. This flood of capital also brought new innovations in products designed to speculate in currency, energy prices, and commodities in general. They even produced a product that allowed you to speculate on a company’s likelihood of defaulting on its debt (the infamous credit default swaps).

The success of hedge funds in these dubious new activities disrupted stock prices [and] currency values, drove up commodity prices, and created volatility in all markets. Their success also seduced banks, mutual and pension funds, as well as individual investors, to gradually overcome their fears and give way to their greed.

The Federal Reserve poured gasoline on an already overheated investment environment by dropping the key discount rate to 1%. This move stimulated even more activity in what is termed the “carry trade,” where hedge funds borrow massive amounts of short- term funds and invest them in higher-interest-bearing, longer-maturity securities.

It also stimulated what was to become the greatest-ever housing boom, which took on a “carry trade” structure in that unqualified buyers (overleveraged) were able to borrow at short-term interest rates (adjustable-rate mortgages) in order to buy a long-term asset (a house). Continuing this housing boom became a problem as the market ran out of qualified buyers who could meet the Fannie Mae and Freddie Mac guarantee standards. Not to worry: Wall Street found its own solution by creating collateralized mortgage obligations (CMOs), which packaged mortgages into pools of good and not-so- good mortgages.

The collapse of a few CMOs brought to light their lack of transparency (a classic pig-in-a-poke problem) and led to media reporting that these structured financial vehicles were not silk purses but sows’ ears. The lack of transparency of CMOs lead to tremendous discounting of values in a market dominated by desperate sellers.

Meanwhile, the credit-rating agencies went on a rating downgrade spree in anticipation of all the balance sheet erosion bound to result from the accounting losses. This led to various stock market bear raids first against the municipal bond insurers and then the banks and investment banking firms which held the now designated “toxic” securities. The 24/7 media couldn’t get enough and provided a handy forum for anyone with a bad word and a penchant for 15 minutes of fame.

Investor confidence quickly became an oxymoron. Irrational pessimism led to fear and fear became panic. Clearly it was time for government to step in and in its inimical way, really get things cocked up.

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