The Magazine

Confidence Game

A McCain agenda for financial recovery.

Mar 31, 2008, Vol. 13, No. 28 • By DAVID M. SMICK
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The most dangerous time politically for John McCain is between now and Labor Day, when the GOP convention begins. Democrats, including 527-funded outside groups, will attempt to marginalize him on the domestic front. With the collapse in consumer confidence and the ongoing credit crisis, they will attack the Arizona senator (who admits he "knows nothing" about economics) as, economically speaking, a third term for George W. Bush. The charge will gather credibility as the U.S. economy continues to weaken.

During the Republican primaries, McCain scored points by talking about fiscal responsibility and with attacks on earmarked pork barrel spending. Yet as a general election approaches with the credit system at risk, speeches centering on budgetary bean counting sound strangely irrelevant. When the house is on fire, it isn't the time to do an inventory of the furniture in the front parlor. McCain needs to campaign on a set of bold economic policies.

Arriving at a set of policy solutions, however, won't be easy because the credit crisis has been resistant to conventional policy measures. In recent weeks, the senator has praised the Federal Reserve for its cuts in short-term interest rates, and he supported the bipartisan emergency stimulus package passed in early 2008. Yet these are little more than painkillers. They may lessen the severity of the subprime-related symptoms of the contraction of the credit markets, but they are inadequate in dealing with a problem in the financial system's very architecture. What is at issue for the next president is a problem that was brewing long before the housing bubble burst. At issue is a fundamental and increasing distrust of the asset-backed securities market, one of the main arteries of the global credit system.

For the past decade, the large global financial institutions have flooded the world with asset-backed securities where the "asset" is often a collection of securitized mortgages. Here's how the system works. Senior financial executives lump the mortgages into a pile, divide them into multiple interest-income streams, and for a fee sell them as mortgage-backed securities. The only measure of risk and value of these new securities comes from the credit rating agencies, which measure risk based on sophisticated mathematical models. In this new system, the lender therefore no longer has any connection to the lendee--or the need to worry about whether he or she will pay back a loan. For the bankers and investment bankers, the goal is no longer risk management but risk dispersion. A system of diminished transparency depends on the broader market's confidence that the mortgage-backed securities reflect a viable value. Today there is sudden, widespread distrust of these complicated financial paper assets.

Under normal conditions, the financial system would have relatively easily absorbed a subprime mortgage problem amounting to a mere $200 billion in securitized exposure in a global market worth hundreds of trillions. What the markets couldn't tolerate was the discovery of the legal but dubious system that banks and investment banks set up in the past decade to obscure risk--especially mortgage risk. It is the independent, off-the-balance-sheet vehicles (called conduits or structured investment vehicles) set up by the large financial institutions which triggered the credit crisis.

Why would a bank set up a separate vehicle where the parent bank is not even listed on the balance sheet as a primary beneficiary? One word: greed. The large financial institutions created their own private market--a kind of automatic, legal dumping ground of risk with the added bonus of enormous profits.

The large institutions brazenly encouraged their independent vehicles to buy the parent's mortgage-backed securities, some containing significant amounts of subprime exposure. Using these securities as collateral, the independent vehicles went to the global credit markets and borrowed by issuing commercial paper (unsecured short-term debt that is one of the backbones of the cash-like money market funds). When the housing bubble burst, the sudden strain in the commercial paper market put the independent vehicles in real jeopardy.

The parent banks hadn't counted on the fact that, in a global market, traders don't distinguish between the off-the-balance-sheet vehicles and their big parent banks. With the independent vehicles in trouble, the parent banks were seen as in trouble. Bank stocks collapsed, global credit seized up, and even ultra-safe money market funds were at risk. Investors, fearful of holding paper assets of dubious value, poured into short-term government bond markets and commodities, especially oil and gold, for the comfort of assets whose value can be physically measured.