A Year of Chaos in Finance By FLOYD NORRIS

December 19, 2008
High & Low Finance
A Year of Chaos in Finance By FLOYD NORRIS

Long-term interest rates are at their lowest level in half a century.

Long-term interest rates are at their highest level in nearly 20 years.

This is shaping up as the worst year in seven decades for the stock market. Of the 10 best days the stock market experienced during those 70 years, six came in 2008.

A Wall Street legend who became a hero for forcing Wall Street to treat investors better now admits to defrauding a later generation of investors of $50 billion. A prominent lawyer is said to have embezzled hundreds of millions by selling fake securities to hedge funds.

The economists are worried about deflation. They are also fearful of inflation.

The government is lending money to businesses that could never before have borrowed from it. People fear a wave of corporate bankruptcies as companies find they cannot borrow money to repay loans that are due.

This was the year the financial system stopped working. Nearly all the contradictory, but accurate, statements above can be traced to that fact.

In 2007, the people who ran Wall Street, and the ones who regulated it, did not understand how serious the financial crisis was becoming. They saw the primary problem as one of a housing slowdown caused by a subprime mortgage crisis, and assumed the securitization machine — which had come to finance everything from corporate loans to credit cards to student loans — would keep on ticking even if its mortgage factory could keep operating only with the government guaranteeing almost everything.

In 2008, the government effectively nationalized Fannie Mae, Freddie Mac and the American International Group, and it bailed out those who had lent to Bear Stearns. It let Lehman Brothers fail, briefly reassuring market ideologues but terrifying many market participants, and the rout was on.

The securitization machine ground to a halt, and the banking industry was in no position to assume its historical role as a lender that patiently waited for loans to be repaid. To the contrary, banks trusted neither their own balance sheets nor those of other banks. For a significant part of the economy, the government became the lender of first and only resort.

For most of 2008, the Federal Reserve and the Treasury failed to realize that the banking system faced a solvency crisis rather than a liquidity crisis. Liquidity-providing moves proved ineffectual because no one had confidence in the values of enormous amounts of derivatives and securitizations that the banks owned.

“No financial market can function normally when basic information about the solvency of market participants is lacking,” wrote Michael D. Bordo, a Rutgers economist.

A year ago, China and India were supposed to be the engines that kept the world economy moving forward even if the United States was applying the brakes. Now people worry that rising unemployment could lead to political instability in the Asian giants.

A year ago, most economists — including the people setting Fed policy — thought the American economy could avoid a recession. Now they have concluded that one was already starting as 2007 ended, and the optimists think it will last for six more months.

With commodity prices collapsing, and consumers feeling poor and expecting jobs to vanish, the inflation rate went from alarming to negative and the Fed cut the short-term rate it controls almost to zero.

The rate on 10-year Treasuries fell to a little over 2 percent, something not seen since Eisenhower was in the White House. But an index of junk-bond yields soared to more than 17 percent, just a little below the record level set during 1990, the last time the banking system appeared to be ready to collapse. Money is cheap for the government and unavailable to those who need it most.

The multiple ways being used by the Fed and the Treasury to push out cash mean the government will end up with a lot of assets of questionable value. That amounts to printing money, and economists worry that if the Fed is unwilling or unable to tighten when things turn up, that could lead to rampant inflation.

There could be a significant political constituency for inflation by then. If the problem is that your house is not worth what you owe on it, a good dose of inflation could produce a solution by raising the nominal value while not changing the amount you owe.

In normal times, after a recession ends and inflationary pressures build, the Fed tightens by selling Treasury bills for cash, a move that sucks cash out of the economy.

After this recession, its balance sheet may be heavy with mortgage securities and perhaps even corporate debt, and the Fed may have to sell them, rather than nice safe T-bills, to tighten credit. That could work out nicely if economic recovery has by then made those mortgage securities appear to be safe and reliable. That is one bet the Fed is making by taking on assets it never would have considered in the past.

It is in booms that the seeds of busts are created, and the heroes of one era can be the villains of the next. The securitization machine that is so vilified today played a major role in greasing the boom that preceded it.

That can even be true of people. One reason for the development of the great bull markets of the 1980s and 1990s was the freeing of investors from high fixed trading costs. To many — including some regulators — much of the credit for that went to a feisty trader who found ways to maneuver around the system and let investors and speculators trade for less. His name was Bernard L. Madoff.

Four decades after he started that fight, which made him rich as his firm became the largest player in the Nasdaq stock market, Mr. Madoff admitted that his later success as a money manager was all a fraud. He estimated the losses in his Ponzi scheme at $50 billion.

The disclosure of that fraud came on the heels of the arrest of Marc S. Dreier, a well-known New York corporate lawyer who had gotten hedge funds to lend many millions to real companies they believed to be Mr. Dreier’s clients. The cash actually went to him.

The falls of both men may be due in part to the sudden need for hedge funds to come up with cash to pay nervous investors. It is during bear markets that the follies of the previous bull markets become starkly apparent.

This is my last column of 2008, as I head off to vacation. Given how badly the forecasts for 2008 worked out, it would seem foolhardy to offer any for 2009. But one seems clear to me: One of the most important tasks for the new administration’s economic team is to put together a financial system that will be able to grant credit and pay for investments when the recession nears an end.

If they fail to accomplish that, and are unable to couple it with a regulatory system that will neither smother innovation nor let it run wild, then the commentaries a year from now will be even more downcast than those appearing as this year draws to its sad conclusion.

Floyd Norris’s blog on finance and economics is at nytimes.com/norris.