Throughout my lifetime, and that of my parents, economic prospects and growth were always a direct function of the availability of money and credit, and the expectations of the participants in the local and [more recently] the global economy. If money was easy to obtain, and businessmen or farmers were optimistic about the future, and felt that they could make a good profit, they would invest in their businesses, and buy new equipment or technology to make more product, or to manufacture more efficiently. They did this because they were confident that their investments and the return on them would eventually flow through the bottom line of their businesses back to them.

Things are backwards now for several reasons. First, since the new administration came to power in the U.S, the government has taken over large swaths of the economy, much like the British labor governments of the ’70s. The automobile, banking, energy, and healthcare industries are cases in point.

What would you do, if you took over an automobile company, and like ‘The Producers’ you wanted to make sure it would fail?

First, you would stock the upper management with people who had no previous experience running a car company.  Check.

Then you would make sure it was strangled in regulations and accountable to no one but yourself. C heck

Then you would make sure it produced cars that were expensive, impractical, and that no one wanted. Check.

Then you would make sure that the unions, who, in large measure, were responsible for the company’s previous prohibitively expensive cost structure, would be given a strong voice in the day-to-day operations of the company. Check.

Then you would take the company through bankruptcy and allow the unions to take precedence over the bondholders. That way, you’d make sure that further issuance of debt would be prohibitively expensive. Check.

Speaking of bondholders, the government is steamrolling them in the case of GM to accept a lower order of precedence than the unions in the impending bankruptcy. It’s the little guy who’s getting screwed because the institutional holders of the bonds have already bought swaps which will pay off when GM enters bankruptcy. Smaller holders have no such insurance, naively believing that their bond covenant would protect them with priority as the company’s assets are liquidated. News just out suggests that 54% of the bondholders agreed to swap their stake for 10 % common stock in the reorganized company, plus warrants. This is a bad deal for the minority bondholders.  And already the Treasurer of the State of Indiana has threatened to exclude new bond purchases from other companies who have a union presence.

I’ll address the other government run industries in a moment. But I would like to note that I can’t find an example of a successful American company that has been run by either the government, or the unions. The proposed configuration is bad for both GM and Chrysler, but also for Ford, who must now compete with the two other companies with substantial government investment. Don’t forget: the government owns the board, and the game.

The U.S. government also has a substantial ownership in the financial industry. The original stimulus plan forced the nine largest banks to accept government money in return for preferred stock. Healthy as well as unhealthy banks had to accept the deal, under the guise of protecting the weaker banks from disclosure that would further weaken them. Goldman, Merrill, SmithBarney, Wachovia, and MorganStanley were among the top investment banks that were included in the deal along with Bank of America, WellsFargo, JPMorgan and Citigroup.

For many of these banks, it’s like being partners with the mob. The syndicate lends you money, but does not allow you to pay it back. Paybacks must be at the convenience of the government, along with the associated interest. And, by the way, compensation to the highest earners in the firms are subject to government approval. This, of course, leads to an exodus of talent to other, non government controlled firms, creating a ‘brain drain’ which is another name for fleeing of intellectual assets from these ‘beneficiaries’ of government largess.

Even today I have found that jumbo CDs bought from the ‘favored few’ were quoted at up to 100 basis points less that those offered at smaller S&Ls or Credit unions. There’s no security premium on these either, as each offers the same level of FDIC insurance in case of bankruptcy.

The government doesn’t own any energy companies per se, but creates an endless series of regulations which ties the industry in knots. For all the energy shortages in the past several years, one would think that the government would be encouraging exploration and drilling. Not the case. No new offshore leases have been granted for years. I n the past, the leases were sold in packages. The winning bidders would take their package and drill on the sites they thought would produce oil/gas. The rest would be abandoned as unprofitable. There are currently huge tracts of oil and gas deposits on the California, Gulf, and Atlantic coasts which contain huge amounts of deposits, but which are untouchable because the government refuses to allow drilling. The coast of California has been off limits for 30 years now, depriving that state of the revenue it needs to balance its budget now.  And in the meantime, China has made a deal with Cuba to drill for large oil deposits in the Strait of Florida.

The same is true for huge natural gas deposits in the ANWR region of Alaska, the midwest, not to mention the shale oil deposits available in Colorado.

Now there is a plan to impose a ‘cap and trade’ tax on energy production in this country, under the guise of improving the environment. That will assuredly bankrupt several Appalachian coal producing states, in addition to giving many of us a 50-100% increase in the cost of our electricity.

The prominent proximate causes of our current economic situation all can be grouped into one:  unsupervised speculation on a grand scale using other people’s money.  Used to be that local S&L institutions accounted for the majority of home lending.  Little S&Ls like Mr. Potter’s in ‘It’s a Wonderful Life’ would assess the credit worthiness of a local homeowner or farmer, and lend its capital to fund the endeavor.   They knew the borrower, and could keep tabs on his ability to repay.  It was the S&L’s money, so if the borrower faltered, the lender could step in immediately and sell the property and recoup their assets, or help the borrower to make good on his load.  More importantly, the lender, because his own money was at risk, took particular care to see that this was a good investment for him!  Over the past 20 years or so, somebody got the idea that the banks and S&Ls could bundle those loans, and sell them on the open market.  That would allow the S&L to make more loans with the proceeds, and if the market for these mortgages were liquid enough, the investment banking community could make money trading those packages of loans.

Once upon a time, the investment banks were all private partnerships:  Bear Stearns, Goldman Sachs, Merrill, Paine Webber, Kidder, Drexel Burnham, Lehman Bros, – all of them were partnerships, capitalized exclusively by the wealth of the partner-owners.  Starting roughly in the 1980s, those partnerships began to disappear, as the enterprises needed more capital to fund the expansions of their forays into the capital and private equity markets.  Junk bond trading added leverage to the mix, and soon these guys were making money like never before.  There was so much money to be made that lucrative arrangements were made withthe traders, who carried home at the end of each year, a significant portion of their profits, aided by the leverage and access to capital provided by their employers.

Enter stage left, the government.  Under the Community Reinvestment Act, passed under President Carter, and later augmented by President Clinton, the government embarked on a program to extend home ownership to people with lesser amounts of capital.  The mortgage packages referenced earlier that were sold by the local S&L institutions were guaranteed by Freddie Mac, and Fannie Mae.  And, as a matter of fact, the executives of these quasi government entities had their compensation arrangements changed, so that they were paid based on the volume of loans they processed, rather than on the profits of their institutions.  The Fed made the cost of capital cheap by keeping interest rates low.

So now we have a perfect storm:
A whole new class of buyers are enabled and rush to buy houses with cheap, almost guaranteed mortgages using other peoples’  money.
This creates a significant inflation in the value of houses.
The housing inflation attracts speculators like sharks who buy multiple houses to flip them for a profit – using other peoples’ money.
The housing inflation prompts other homeowners with a little more capital to take out homeowner loans and buy Cadillacs or whatever- using other peoples’ money.  They are enabled by the artificial and temporary increase in the valuation of their homes.
The S&Ls and making money hand over fist- lending money to anyone who can fog a mirror, then flipping those mortgages through Freddie to the investment banks – laying offtheir risk to other people.
The investment banks are trading up a storm and making a ton of money- using other peoples’ money.  And so are the traders- using other peoples’ money.

And even us guys sitting in the bleachers are pleased as punch to see the value of our houses soaring.  We’re high-fivin’ each other at our kids’ soccer games and at cocktail parties – all thinking about how smart we were….

Until housing prices peaked, and Bear and Lehman failed.  (Technically only Lehman failed.  Bear was ‘rescued’ by a shotgun marriage.)  Those events brought about the credit spasm in September 2008, and have set the stage for further disasters to come.

The credit crisis has now spread into other industries – housing, investment banking, banking, mortgage, automotive, applicance, etc.  And now that the housing market is 20-50% below where it was just a few years ago, there are many houses ‘under water’- that is worth less than the money advanced to buy them.  In some cases, homeowners are abandoning their houses rather than pay their mortgage.

The key question now is how to untangle this mess.

Should unwise buyers be protected?  The arguments for this are that liquidating the houses under water at fire sale prices would depress other adjacent housing values, and that these are the least able to afford a foreclosure.

Should the mortgage holders be protected? The arguments for this are precedent, and the rule of contract law, which is the basis for business transactions around the country and around the world.

Should BOTH be protected? Should the government use taxpayer funds to bail out certain holders. This will cause a huge burden on the treasury, and on the obligations of our children and grandchildren.  And it would set a very bad precedent.

Choices 1 and 3 will inevitably lead to a longer and more protracted, though not as deep housing slump.  Choice 2 will lead to a sharp decline in housing prices, as a large ownership migration takes place almost immediately.  But all other things being equal, there should be a sharp rebound in housing values once the flush is completed.  But then again, other things rarely ARE equal.

A similar quandry is being faced by the GM bondholders at this moment.  Should they step aside and settle for a small percentage ownership of GM, or should they assert their right of precedence in the liquidation of GM?

I hope they choose the later.  Because if they do not, it will deal a cruching blow to our credit markets.  If they are steamrolled into abrogating their rights under the debt covenants they hold, the markets appetite for corporate bonds will dry up like a raisin in the sun.  Already the treasurer of Indiana pension funds is thretening to unload and refuse to buy the bonds of any company with a union presence.  That would be a VERY disturbing omen!