What's That Noise?! [Ian Kallen's Weblog]

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20081130 Sunday November 30, 2008

Big Is The Problem

I usually don't rant about economics but I wasn't shopping on "Black Friday" (nor will I be tomorrow on "Cyber Monday") - I'm trying to figure out how to tighten my belt. How it is that I, someone outside of the real estate, finance and auto industries that are so problem plagued, am getting caught in our economy's downdraft? Well, let's see.

Last January, Business Week raised the question "When is an institution too big too fail?" Until September of this year, the financial industry's downward spiral meandered along, like a persistent flu. There were bank failures but the conventional wisdom seemed to be that this was the market at work, winnowing the weak. The bad news ebbed and flowed: mortgage failures, rising oil prices and the weak dollar were countered by stimulus package checks, housing sales leveling off or even rising (where prices crossed their local tipping points) and vibrant web 2.0 and green enterprises. There had been bank failures this year but it took the evaporation of really Big institutions, Lehman Brothers and Merrill Lynch to put Business Week's question on everyones lips. To free market purists, the answer is obvious: whatever may come, let the failures fail. But the reality is that when an enterprise is so big that its failure disrupts significant portions of the overall national and global economy, whatever may come of its failure won't be good. Everyone suffers and bigness is the problem. When these companies become indispensable institutions, we should be afraid.

It seems for years there's been a breakdown in accountability. Loan originators could resell their loans and write new ones, no harm no foul. Right? But one of the key problems with that system is that the originators don't have any skin in the game. The have a money merry-go-round and whoever is left holding the paper (big institutions and their investors) draws the short straw. It's total madness. To date, all of the bank failures have resulted in consolidation in some form or another. Lehman is absorbed by Barclays. Merrill by BoA (which already absorbed Countrywide). The big are getting bigger as the competitive field shrinks. Ironically, this perpetuates the problem: bigness. What happens when Barclays or BoA start wobbling next? Now we have yet bigger institutions that are again too big to fail.

Among the remedies dismissed by free-market adherents is one of the Federal Government investing, taking an ownership stake in the banking, insurance and auto giants who have exposed themselves to risk that has subsequently blown up in their faces. "The government won't know any better how these companies should be run" goes the admonishment. But as if it isn't clear by now, the executives paid the big bucks to know how they should be run apparently don't either. As Newsweek explains in The Monster That Ate Wall Street - How Credit Default Swaps Became a Timebomb, the financial industry had no shortage of creativity when it came skirting the liquidity requirements imposed on them in the years following the S&L crisis. Is it really such a surprise? Michael Lewis (Liar's Poker, Moneyball) recounts in The End of Wall Streets Boom (Portfolio Magazine / December 2008), there were those calling Bullshit but things were just going too damned well for those alarms to be heeded.

It's unescapably clear now that the old adage applies, "if it's too good to be true, it probably is." Until recently, I thought this was only impacting me with the difficulty I had getting my mortgage. But no, the cavalier rating agencies ("the fox was guarding the hen house"), excessively leveraged financial arrangements and detached accountability have led us down this financial rabbit hole into what some now describe as a death spiral. It's not just a Wall Street problem, it's spillover to Main street has cacaded down Sandhill Road. Here's the ominous and infamous slide deck from Doug Leone and friends at Sequoia Capital:

These slides were cited during Technorati's company meeting last week around the layoffs and salary cuts. That really dropped the dark cloud of what's happening in the broader economy close to home.

As bummed as I am about seeing colleagues depart and seeing my paycheck shrink, I'm actually optimistic about the future. Valuations on real estate seem to be reaching reality: they're hitting thresholds that people can afford with conventional financing. Technology continues to fuel innovation and innovation holds the potential to re-shape markets. Come Inauguration Day, it looks like Obama is coming into office surrounding himself with a team of economic advisors who are committed to preserving free markets but are also not so steeped in ideology that they're paralyzed about how to intervene.

I'm looking forward to this cloud lifting. That's my rant.


( Nov 30 2008, 06:05:51 PM PST ) Permalink


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