Tuesday, May 26, 2009

Two fuses linked all the nastiest bits of the 2008 Economic Collapse

Seven years before, in 2001, with the genuine concern and hypocritical posturing that followed the Enron collapse, a law was passed in Congress known as Sarbanes-Oxley that required that securities (bonds, stocks, other fiduciary instruments) be valued at current market prices on a corporation's balance sheet. The valuations had to be current; the standard of what is current was made the current day's price. This was to prevent the vastly overstated valuations that had supported Enron, prior to its collapse.

That was the first fuse.

The PBGC - Pension Benefit Guarantee Corporation - is a quasi-government agency, set up to prevent other past scandals. At some point, PBGC required that the securities held by pension plans must be insured by private insurance before PBGC would guarantee the pension plan. The meant that all sorts of bonds had to be insured with companies like AIG. Premiums were paid on even municipal and state bonds, which have extremely low default history as they are guaranteed by tax revenues.

Sounds great - protect pension benefits with insurance . . .by law. This was the second fuse.

The Economic Collapse of 2008 was not every one's fault, but almost. There is plenty of blame to spread around . . .but this is how it happened.

Insurers like AIG faced their own collapse, due to their guarantee of mortgage-backed securities that were rated by the rating agencies from wonderland. When those insurers defaulted, their insurance on an entire range of securities vanished overnight.

By law, the trustees of pension funds across America were required to eliminate that entire range of securities immediately because the securities were uninsured. All kinds of bonds and other securities were dumped on the market for sale at the same time. There were nowhere near enough buyers because all of the guaranteed pension plans were selling simultaneously and were forbidden to hold or buy.

Banks and other financial institutions saw the market prices of their capital reserves (held in securities) fall to near-zero - overnight. Prior to Sarbanes-Oxley, the banks would have held their securities and waited for the market to recover but in 2008 they were required to value their reserves at that day's market prices.

In a single day, pension plans liquidated huge volumes of securities because the law required them to do it and the banks were required to value their capital at the near-zero prices that resulted. Immediately other laws governing bank capitalization - passed to protect depositors - mandated closure and government take-over of the banks. All of this happened together, within 24 hours.

The Economic Collapse of 2008 was a government-mandated financial panic - mandated by the laws and regulations mentioned above.

The Economic Collapse of 2008 had many contributing factors but these two fuses set it off.

These fuses were laid by Congress, with noble intentions, 20/20 hindsight and appalling ignorance. Risk is inherent in life. Risk cannot be eliminated by law; risk can only be hidden and/or displaced.