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Epic Fail

The great flummoxing recession of '08.

As investors all around the world ran scared this past month, their panic was about the only thing easy to understand. The global financial system was collapsing and almost nobody could say--in plain English--what exactly was fueling such a gigantic crisis. Not the president, who offered insipid generalities; nor the presidential candidates, who stuck to old themes like earmarks, taxes, and deregulation. Not even Treasury Secretary Henry Paulson, who delivered abstract lessons about liquidity and interest-rate spreads but whose plan for the government to buy "toxic assets"--loans that have little or no market value because of their lack of transparency--misfired and had to be recast as a plan to buy stakes in banks. This has been the Great Incomprehensible Recession of 2008. Incomprehensibility was at the root of the problem, and it is at the root of our difficulty getting out of it.

As the United States struggles to get past the turmoil, the challenge will be to understand its most basic causes. Did the trouble start with the Reagan agenda of deregulation? The Bush era's passive Securities and Exchange Commission and Alan Greenspan's Federal Reserve, with their loose rules governing off-the-books investments and the ratio of capital to lending by financial institutions? The flood of capital into the United States from China and the Persian Gulf? The Federal Reserve's easy money and the failure to regulate complex new derivatives? Or was it the liberal political pressure on Congress and the administration to keep interest rates low and expand homeownership recklessly through Fannie Mae and Freddie Mac? The truth probably includes some role for all these explanations. But the truth has also been radically unclear because of the difficulty in understanding the machinations and statements of the financial wizards handling our money.

Throughout its recent heyday, Wall Street sounded so smart. They developed computer models and complicated packages of assets that seemed to make the risky debt piled on homeowners and consumers look like safe debt. The sheer complexity of these assets masked the weakness in the system. The jargon employed to describe off-the-books "structured investment vehicles," "collateralized debt obligations," and computerized financial models--not to mention the exotic derivatives like "credit default swaps"--was a barrier to understanding how they worked. As Representative Barney Frank says, it has not been easy for even the most sophisticated investment banker to explain the workings of credit default, currency, or interest-rate swaps. Swaps--essentially contracts between two or more parties aimed at hedging against the loss on an underlying asset--are the instruments that Warren Buffett famously once described as "financial weapons of mass destruction." The danger is aggravated by the difficulty in measuring what threat they posed for the institutions--commercial banks, investment banks, mutual funds, pensions, hedge funds, insurance companies--possessing them. There are now more than $500 trillion of such swaps and options notionally coursing through the global financial system, and, while we know that doesn't translate into $500 trillion in risk, no one is sure in the current environment what the actual risk is. Not since the height of the cold war has the fate of the world rested so profoundly in the hands of a priesthood of experts with a monopoly of understanding obscure concepts, if they understand them at all. The expertise of the cold warriors was in throw weights, MIRVS, and the concept of "mutual assured destruction," which was supposed to make us secure. It is not a terribly comforting analogy.

By themselves, swaps have not been a major factor in the current crisis, at least so far. In Europe, there has been a cry for years to regulate hedge funds, which specialize in using swaps and other exotic investments to make bets invisible to normal markets and regulators. Now, to the embarrassment of European and American regulators alike, the latest financial turmoil has engulfed not the hedge funds and other private equity institutions that count on these instruments, but the most regulated part of the system, particularly the major commercial banks. All the explicit government supervision in the world failed to prevent them from investing in packages of subprime mortgages, which seemed like a sure thing as long as home prices rose ever higher. You could not go wrong even if a mortgage defaulted, the logic went, since the underlying home value seemed destined to rise in perpetuity.

But the values did go down, starting in 2006. Now we do not know how much further the values will plunge, and the extent of the hole these now-"toxic" assets--in the form of mortgages, mortgage backed securities, and other forms of debt--leave in the books of large and small financial institutions in the United States and Europe. Earlier this month, the toxicologists at the International Monetary Fund, declaring that the United States remained the "epicenter" of the global credit meltdown, estimated that losses on U.S. loans and securitized assets would likely increase to $1.4 trillion. (In a sliding economy, such sums are the ultimate moving target.) There are no certain figures about the holdings of such assets in European banks, but the number is clearly large and subject to panic there, as well. Without knowing who holds what, and what the assets are really worth, it will be difficult to know if a solution is at hand.

Like wars, financial crises always unfold in unexpected ways. Problems that are poorly understood require solutions subject to revision and reconsideration. That's why each new step taken by the Federal Reserve or the Treasury intended to stave off the horrors of collapse had such a short shelf life. At first, Paulson was praised for letting the house of Lehman go under; thank goodness the Treasury was not going to bail out everyone, people said. Moral hazard--the concern that, if you do not pay for your mistakes, you will repeat them--was countered. Now the conventional wisdom is that Lehman's wipeout accelerated the global panic. We are not hearing too much these days about moral hazard. A few weeks ago, the Treasury opposed direct federal investments in banks and financial institutions. When the Emergency Economic Stabilization Act of 2008 was signed into law, Paulson said it would be wrongheaded to use the $700 billion appropriated by Congress for such an intrusive enterprise. Now Paulson has flip-flopped, and at least $250 billion is to be spent on investments that can be seen as a kind of partial nationalization of the banking system.

There is a final irony about the issue of how much we know and how much it is healthy for us to know. Are there instances, in moments when markets are panicking, when it is better to reassure the public than to strip the system of its mysteries and let people see how precarious it is? If we could know how many of the assets of major banks are toxic, would we want to know? Would knowing everything about the threats to the system hasten a solution or realize the threats?

Under the Troubled Asset Relief Program (TARP), for example, Paulson is still supposed to purchase some of the toxic assets with his remaining $450 billion from the banks and resell them when they regain value. But there remains a problem of deciding their price, which Treasury has been given tremendous latitude to determine. Beyond that problem, economists and regulators disagree over whether it is healthier for banks and other institutions to value their "troubled" assets at their current distressed market value (known as "mark to market") or at the value based on the revenue they are projected to generate over their lifetime. Sometimes, it must be said, discretion is the better part of leadership. When Paulson said at the outset that Treasury was going to buy troubled assets from banks but not make direct purchases of bank shares, he may have thought at the time that the second step would be unnecessary. Or he may have thought that signaling his backup plan guaranteed that the original plan would fail.

Economic crises are never so easy to decipher when you are still in the midst of them. Even afterward, it can be difficult. We're still debating the causes of the Great Depression and which parts of the New Deal worked. The first priority for long-term reform must be to make the entire global financial system more transparent, comprehensible, and accountable without imposing too many new restrictions. We need stricter oversight by the Treasury and the Federal Reserve, both of which have been lax for years, and more public understanding of what that oversight is and is not doing. A nation or collection of nations that does not nurture a healthy regulatory system runs the risk that the people in charge lack a fundamental understanding of the system's weaknesses and have little incentive to look for clues to possible failures when times are good. While the best system might not have been enough to forestall catastrophe, it might have prevented us entering this crisis feeling so helpless.

Steven R. Weisman is editorial director and public policy fellow at the Peterson Institute for International Economics.

This article originally ran in the November 5, 2008, issue of the magazine.