A Crisis of Confidence Indeed
The turmoil on Wall Street that culminated in the Chapter 11 bankruptcy filing of Lehman Brothers and the emergency acquisition of Merrill Lynch by Bank of America are more dramatic steps towards an unknown climax. And it’s not just the surface-level detail that’s scary. Sure, another storied investment bank finds itself insolvent while another needs emergency injections of capital to prevent insolvency. However, what raises the eyebrow is that this is another chapter in a revealing story about what our modern financial system has become, and the story that is being written before our eyes is more tragedy than comedy.
President Bush, Treasury Secretary Hank Paulson, and Federal Reserve Chairman Ben Bernanke have all referred to this crisis as a ‘crisis of confidence’ at one point or another. They are right. But the confidence that is in crisis is not what you think. It’s not confidence in the U.S. Economy or in American ingenuity. It is deeper and more foreboding than that. This is a crisis of man’s confidence in man.
Man’s Confidence Man
In the late 1800s, there was a large plaque that sat in the original Dun & Bradstreet headquarters on 99 Church Street in Manhattan, which since has been forged into several duplicate statues that are now found in offices and banks around the country. The plaque was commissioned during a time in which the extension of credit was a great innovation, not to mention a novel concept, that helped fuel the United States’ westward expansion. The plaque was adorned with the image of two men, a farmer and a laborer, holding hands in a display of confidence in the oaths they had just made to repay the debts they just incurred to strike out on the American Dream. Engraved on the plaque was a quote from a speech given by then-Massachusetts Senator and later U.S. Secretary of State Daniel Webster in 1834:
Credit. Man’s Confidence in Man. Commercial credit is the creation of modern times and belongs in its highest perfection only to the most enlightened and best governed nations. Credit is the vital air of the system of modern commerce. It has done more — a thousand times more — to enrich nations than all the mines of the world.
How true it is. The ability of a person to gain access to capital that he or she can employ – merely with the promise to repay and irrespective of whether one was from an aristocratic or common laborer class – is one of the defining characteristics of the land of opportunity. However, if a nation begins to dishonor this obligation and behaves in less-than-enlightened ways, and consequently ceases to be one of the “best governed nations” as noted by Webster, the foundation upon which prosperity is built erodes.
The tragic story being written before our eyes – this crisis of confidence – is about the erosion of trust, and lately new chapters are being added. The downfall of Bear Stearns, the Fed’s intervention into the mortgage mess, and the volatile price of oil are all tales that tell how the trust that underlies the system is eroding. Future chapters will chronicle the results that these cracks have in foundations of institutions, just like these cracks brought down household names like Washington Mutual (click here for details on WaMu’s crumbling foundations) and AIG (click here for details on AIG’s struggle to stay liquid).
However, the moral of the story is that trust is being lost because the fix is in on Wall Street. Speculators, short sellers, back-alley deals, ill-conceived compensation plans and ‘irrational exuberance’ have thrown risk management out the window and turned the backbone of our modern economy – credit and its underlying trust – into a game of chance. People and institutions have made bets they could not cover, and now vows, covenants and promissory notes are not being honored. In an environment like this, the house wins for a while, but once the hot action cools all that’s left is a house of cards.
Financial Murder and Compulsive Gambling
Take the fall of Bear Stearns. Bryan Burroughs, in the August 2008 Vanity Fair, profiled what had been widely speculated and what many take as Gospel: that Bear Stearns didn’t just fail, it was murdered. Murdered by short sellers seeking to profit from rumor-fueled speculation that it was approaching illiquidity. In a market built on reputation, trust and the ability to cover ones debts, speculation of this kind can kill even the most storied firms. The lifeblood of investment banking is its ability to tap funding to fuel investment activity, and when that dries up due to a lack of confidence in the firm’s ability to meet its obligations, investment banks die.
If the fall of Bear Stearns is evidence item A that the fix is in, take the Fed’s takeover of Freddie Mac and Fannie Mae as evidence item B. Fannie and Freddie’s indulgence in subprime mortgages – the riskiest of all – showed a willful disregard for the required principles of confidence and trust. These mortgages – sold to consumers with tenuous financial profiles – were later baked into so many exotic financial products sold into the far reaches of the system that soon nobody could tell the difference between a well-backed financial product from a highly risky one, undermining the market’s ability to make decisions based on sound information and known exposure to risk. As a result, the financial system’s perceived abilities to honor its obligations weakened dramatically, and eventually the whole system froze.
In hindsight, we all know the mortgage industry gambled with a fervor usually seen only on the floor of the Golden Nugget rather than in the lobbies of fine institutions like Washington Mutual. But Washington Mutual, dime-a-dozen strip mall mortgage brokers, and other organizations continued selling these mortgages on premises that were unsustainable, depending on perpetually increasing home values in markets where inventories clearly outpaced actual people who needed housing. The fundamentals didn’t support the mortgage bubble, and so it burst, leaving the greedy in a hangover from which they, and consequently we, have yet to recover. See MSNBC’s take on the Mortgage Mess, and CNBC’s great documentary House of Cards for more.
Financial Manipulation, Drainage and Milkshakes
Many believe the same type of trickery is happening to the skyrocketing and plummeting price of oil. Is the price driven by supply and demand? Some say no, and suggest that someone is counting cards and playing the system in order to create a profit. Conspiracy theorists actually have agreement from a number of credible, influential industry insiders on the idea that fluctuating oil prices are largely due to speculators taking advantage of and amplifying volatile market conditions at a time when the market is already prone to swings. This kind of opportunity is a prime target for speculators, and these quick ups and downs are just the kind of fast action they like. When the price of gas skyrockets on a holiday weekend, like it did on July 3rd, 2008, people pontificate about supply and demand. When it drops again two weekends later, people wax on about how Americans cut back and discuss the incredible effect growth in China and India has on oil prices. Did 100 million cars hit the road in China and India just ahead of the U.S. Independence Day holiday, and then come off the road two weekends later? Of course not. That’s Dr. Seuss silly.
The price of oil is not following the more correlated trends of supply & demand, but in fact it defies them with regularity. Look how prices over the course of the summer of 2008. They dramatically spiked in the months of July and August – which are supposedly heavy drive times according to the AAA. Then, prices fell again on September 15th, after a Hurricane Ike slammed into the Gulf Coast, which in theory should raise oil prices (prices fell below $100 a barrel!). Many say that these price fluctuations have less to do with the true ebbs & flows of supply and demand and more to do with the various participants in the world’s financial markets who are looking to profit in the short term on these ups and downs. Whether that’s verifiably true or not, what is agreed-to fact is that people are no longer sure one can trust the markets to appropriately value an asset. CNBC, in their daily coverage of the markets, has gone as far as to display what they call the ‘fair value’ of a stock or commodity future, next to which they list where the value of the stock or commodity is trending. It’s a key to tell you whether the market is right or perhaps pulling a fast one.
Thankfully, the oil speculation issue has grabbed the attention of regulators. Robert McCullough, head of the cleverly named McCullough Research, issued a press release of their own saying they are scheduled to speak to members of the U.S. Senate Committee on Energy and Natural Resources this month. Said McCullough in this press release, “The resemblance of the July 3, 2008 oil price spike to Enron’s market manipulation during the California energy crisis in 2000-2001 is eerie. Even more troubling is that data gathered by FERC, the FTC, the CFTC, and the EIA is too insufficient to determine whether the price of oil was manipulated.” A market without transparency is one you can’t fully trust, and as a result of all this, the Senate and others are jumping in to put a microscope to large energy speculators and how they trade. Perhaps change will come about as a result.
No matter what we do, we know one thing – man’s confidence in man has been shaken, and it is yet to be seen if we can fully recover. In our economic world, too many people are playing the part of Daniel Plainview, the greed-driven oil speculator in the movie There Will Be Blood, the 2007 period piece based on Upton Sinclair’s novel Oil! In the movie’s famous last scene, Daniel Plainview exacts revenge on Eli Sunday, the minister boy who is the bane of Plainview’s life for forcing what he views as artificial piety. Before bludgeoning Eli to death with a bowling pin, Daniel explains to Eli just exactly how he outfoxed Eli with a behind-the-scene deal to gain access to the Sunday Family’s land, which he then drained dry of precious oil. Said Plainview:
DRAINAGE! Drainage, Eli, you boy! Drained dry, I’m so sorry. Here…if you have a milkshake, and I have a milkshake, and I have a straw, there it is, that’s the straw; see, watch it! My straw reaches across the room and starts to drink your milkshake: I DRINK YOUR MILKSHAKE! I drink it up!
Stolen right out from under him. Someone’s been drinking our milkshake. Now that we have been once bitten, we will be twice shy in investing, lending, borrowing, and repaying? Has our confidence in the markets, in transparency and in oversight all but been shaken? Time will tell. One thing we know for sure: The most enlightened and best governed nations depend on the recovery of man’s confidence in man.
