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Q1. Why isn't the financial crisis on Wall Street palpable on Main Street? Although financiers, journalists and politicians have been warning of a major financial crisis, as big as the Great Depression, since August 2007 (some economists have been warning for several years now), normal economic activity seems unaffected, or at least the common man does not seems to feel any impending doom. Why is this so?

A. To a large extent, the current financial crisis does not involve the working capital of the American economy. The funds available with the commercial banks, community credit unions and credit card companies have been sufficient to keep business investments, payrolls and consumer spending going on in the near-term. Sure enough, the persistent gloomy predictions on the economy seen in the newspapers and television channels, throughout the year 2008, would have had a negative effect on the confidence of the consumers and the business entrepreneurs. This would have led to cutbacks in production plans, tightening of credit, mark-down of inventories and penny-pinching of family budgets. But, on the whole, the real economy has shown unexpected and prolonged resilience. No doubt the action of the US Federal Reserve Bank to pump over one trillion dollars into the economy for over-night and short-term lending has also eased the flow of money. But, the main reason for the disconnect between Main Street and Wall Street is that the financial crisis is concerned with the accumulated capital (as opposed to working capital) of the American economy.

The term accumulated capital refers to the capital held by (i) pension funds which hold the life-time savings of Americans, (ii) reserve funds which hold the accumulated profits of large corporations and private companies, (iii) mutual funds and money-market funds, which hold savings of individuals that are in excess of mandatory life-time savings like social security, and are more freely invested in the markets expecting a better return than from treasury bonds, (iv) endowment funds, held by private trusts, which are collected through charities and donations, (v) hedge funds and private equity, (vi) any other entity that holds capital that has accrued through the savings of individuals, or the profits of private organizations, or the surplus of state, local and federal governments, and is not needed as immediate investment for the day-to-day functioning of the economy.

To provide a perspective on accumulated capital, one may note that the financial wealth in the American economy is estimated to be $40 trillion (ref: Wall Street Journal Oct 1, 2008 article by Professor Edmund Phelps). Wikipedia states that the world-wide value of all pension funds are in excess of $20 trillion; mutual funds total more than $26 trillion. Please note that it is possible that some of the pension funds are invested in mutual funds. Also, I am not aware of what is the exact total sizes of pension funds, mutual funds and other constituents of accumulated capital within America per se, but I would assume that they add up at least to $10 trillion (which, I suppose, is included in the $40 trillion quoted above). In additions, hedge funds have about $1.5 trillion under their management totally, all of which is investments from individuals of high net worth.

Q2. Aren't saving for retirement, insurance and pension systems old phenomena? Why did they bring down Wall Street this time?

A. Yes, pension and insurance systems were already well-developed in the industrial economies of 19th century Europe. There are two major differences this time around. Demographically, the senior citizens of 19th century Europe retained close ties to the younger generations because of genetic, ethnic and racial homogeneity. As a result, the pension amounts received by the retired people were substantially supplemented by contributions from inter-generational and intra-family transfers of wealth. If we go back a hundred or more years, old people lived with their families and helped to bring up their grandchildren. Moreover, hereditary transfer of wealth was still as important as creation of new wealth in the industrial economies of the 19th century. These factors served as economic incentives for the working adult population to provide old-age care for their parents, which supplemented the parents' income from pension. The second difference is that the dichotomy between an empire and a democracy was far more prominent among the nations of 19th century Europe. People felt assured that the social infrastructure provided by an empire would safeguard their standard of living through their old age. Examples of the social infrastructure of an empire during 19th century Europe are the establishment of universal heath care, the administration of the pension and life insurance systems, and subsidized public transport and postal systems. As an aside, it may also be mentioned here that the development of the modern university was pioneered in Germany during the 19th century.

Thus the fundamental reason for the current financial crisis is the time value of money. To maintain the standard of living that people who are close to retirement or have already retired would expect, the income from their pensions have to be substantially larger, in view of the reasons discussed above, than what a senior citizen in 19th century Europe would have received, even after adjusting for inflation and GDP growth. This enhanced pension income would have to come from interest on investments, because the senior citizens who receive them could not possibly compensate for this income with active work. Thus the managers of pension funds found it imperative to look for high returns on their investments. At the same time, since these funds were so huge and so critical to the lives of many millions of people, their investment strategy had to exercise the utmost caution. Diversification served as the compromise in this situation. The managers of these huge funds would invest the major part of their portfolio safely, for example, in treasury securities. A smaller part would be put under the stewardship of the Wall Street firms for more risky investments in the expectation of high returns. Over a period of two or three decades, such unreasonable expectations on Wall Street to keep generating high returns on capital took its toll.

Q3. How exactly did unreasonable expectations bring down Wall Street?

A. When one refers to Wall Street, it is important to keep two types of people in mind. The first type is the senior executives who have gained their credentials through many years of involvement in the traditional roles of investment banking, beginning in the 1950s or later. The conventional wisdom among these people places a lot of importance on trust-worthiness, reputation, people-skills and management techniques as the path to career-success. Advising industrial firms in mergers & acquisitions, underwriting the issuance of company stocks and bonds to the public, helping the government finance a deficit through the purchase of treasury securities for their clients, and trading in securities on behalf of their clients were the main activities of Wall Street firms before the 90s. We note that all these activities required trust-worthiness primarily, and moreover they didn't require much of the firms' own capital. The second type is the smart, innovative PhDs who have arrived on Wall Street starting from the 1980s. These people have helped build the massive computational infrastructure on Wall Street along with the development of financial innovation. Their most valued skills are quantitative and they are quite tech-savvy. On the downside, many of the senior executives making up the first type have come to exercise a lot of political influence which could be illegitimate sometimes. For their part, the tech-savvy 'quants' of the second type have grown-up with post-modern, anti-heroic sensibilities that has no use for honor or reputation, as defined conventionally. However, in spite of their differing attitudes towards reputation and the 'word on the street', when it comes to compensation, both the types would like to cash in on their professional worth right away with large bonuses.

The advent of computers transformed the industrial economy into an information-based economy. This meant that smart people who could devise intelligent strategies to take quick advantage of the flow of information could expect to make large profits, especially from financial investments. Thus, starting in the early 80s, Wall Street investment banks began to make huge profits, aided by their large investments in computers and their new army of smart PhDs. Over the course of the 80s and 90s, the capital in the 'bulge-bracket' investment banks grew from a few tens of millions to one or two dozen billions dollars. The capital in the smaller investment banks and hedge funds on Wall Street produced similar returns. Thus Wall Street turned into a sleek and mean money-making machine. It was for its massive returns on capital that the managers of pension funds and other sources of accumulated capital had been turning steadily to Wall Street. The boom in the technology stocks during the 90s turned the trickle of capital to Wall Street from these fund-managers into a flood. Now, as history would have it, the technology sector went bust in 2000 with the NASDAQ composite index losing more than 60% of its value between 2000 and 2003. This drastic loss of wealth exposed an inability of modern finance theory to figure out how to determine the proper economic value of technological progress. There was a big question about how Wall Street could continue to churn out its massive profits. It was in this scenario, that the smart PhDs on Wall Street stumbled on the great innovation to direct the huge sources of accumulated capital in America and the rest of the world towards solving the long-term demographic incongruities in America. This was how Wall Street came to trade in mortgage-backed securities. In the process, they found a way to keep the money-machine that is Wall Street hum along smoothly for another 8 years.

Now, the smart PhDs that form the second type came up with a lot of innovations to carefully control the risk involved in turning a housing mortgage loan into a hierarchy of claims on payments, called tranches. For their part, the senior executives that form the first type, who had built up a reputation for trust-worthiness over several decades, could borrow money from the pension funds and other sources at leverage ratios of 25 to 30 -- far in excess of the reserve ratios expected from the commercial banks under the regulations of the Glass-Steagal act. This unlikely marriage of old wise-heads and smart innovators on Wall Street was sanctified by the Federal Reserve which kept interest rates low to avoid a slowdown in economic activity, given the tragedy of 9/11. However, from 2007 onwards, cracks in the marriage began to appear one by one, and it became apparent that the party had gone on too long. The smart PhDs had not take into account that the process of securitization separates the property rights on mortgaged homes from the investments on mortgage securities. The home-owner lives under the threat of foreclosure. So, his/her property rights are compromised. The security-owner bears liquidity risk and credit risk. So, his/her income is uncertain. It is plausible that left to themselves the smart PhDs would have, in due course of time, overcome their error by devising a market-based solution that would mutually alleviate the grievances of the home-owner and the security-owner. However, the Wall Street money-machine was on high-gear by then, and it was not designed to slowdown for any eventuality. The senior executives, who were more comfortable with people-to-people communications rather than arcane finance theory, ran to their long-established connections in the political establishment and the media. Moreover, these senior executives decided to play smart. They used the very same unreasonable expectations that society had placed on Wall Street as a bargaining chip to hold society to ransom. Their constant chants were "Bail-out Wall Street, for otherwise there is the 'systemic risk' of a financial meltdown". "It's going to be armageddon, so raise FDIC insurance to $ one million" (CNBC's Jim Cramer). "We're going to see a repeat of the Great Depression's bank runs". Unfortunately, the long sage of bail-outs starting with Bear Stearns in March 2008, then Fannie Mae, Freddie Mac and AIG in September 2008 and finally the $700 billion bill passed now have not stemmed the financial crisis, and the reputation of Wall Street is in tatters. Thus Wall Street was brought down by unreasonable expectations.

Q4. So what about the billions of losses due to mark-to-market accounting rule? Could these losses lead to financial meltdown? Also, why is de-leveraging cited as a reason for the huge losses? Why is re-capitalization of the banks necessary?

A. In view of the explanations above, it is far simpler to think of the situation as follows. The 'bulge-bracket' Wall Street investment banks (that have now been converted into bank-holding companies or have gone bankrupt) had about $20 to $30 billion of capital each. Wall Street was so used to annual returns of 20% or more on capital before the collapse of the technology sector in 2000. To maintain this high rate of return after 2000, the investment banks resorted to leverage ratios of 25 to 30 in their investments on mortgage securities. This means that each of them borrowed about $750 to $900 billion from the pension funds and other sources. The reader might ask what is the collateral for this borrowing? The investment banks would purchase mortgage securities with this borrowing and submit these same mortgage securities as collateral to the pension funds. The payments received from the home-owners on these mortgage securities would be used to first pay the interest on the borrowings from the pension funds, and the rest would be the profits of the investment bank. In view of the leverage ratio of 25 to 30, a net difference of only about 0.8% in the interest rate received from the home-owner and the interest rate paid to the pension funds would ensure a rate of return of 20% or more for the investment bank. However, the problem with this scheme is that the pension funds only had the trust-worthiness of the investment bankers and the mortgage securities as assurance against the money they lent out. Of course, they also had the enticement that only the Wall Street money-machine could provide them the rate of return adequate to keep up with their large pension payments to senior citizens.

With a fall in the house prices, there would be a corresponding fall in the mortgage securities due to the risk of foreclosures. Moreover, these mortgage securities were structured in such a way that foreclosures of mortgaged homes would be reflected in increasing degrees as one went lower down the tranches. Thus the lowest tranches would lose value very quickly in the event of a fall in house prices. So, the pension funds and mutual funds would need to assess the value of the mortgage securities in their accounting books periodically, say once every quarter, to safeguard their interests. For this, they would need refer to the market value of these securities (mark-to-market), and to request the investment bank to replenish the collateral, if there is a drop in the market value of the mortgage securities. Unfortunately, since the leverage was so high, an average drop of 3% in the market value of the mortgage securities could mean that after the pension fund's collateral was replenished, the whole amount of the capital of the investment bank ($20 to $30 billion) would have to be replaced. This was what led to the bankruptcy of some of the large investment banks. The story with smaller investment banks and the hedge funds is similar. Now, if the pension funds simply didn't insist on mark-to-market accounting, then the investment banks would receive regular payments on the mortgage securities from the home-owners. Over time, the pension funds would recover the full amount of their investment along with the rate of interest that the they had expected, with the only risk being that of foreclosures. There would be no risk that the prices of the mortgage securities would fall due to illiquidity in the markets. Thus financial meltdown would be avoided, with or without the existence of the Wall Street firms.

However, this argument turned out to be the Achilles' heel of the investment banks. Working in their old trust-based mentality, they thought they could ride through this financial crisis if they simply convinced their creditors to rescind the mark-to-market rule and give them more time. They didn't find it necessary to sell off the risky mortgage securities and cut their losses, nor were they seriously looking to raise new capital. And they were caught by surprise when the end came. For the same reasons cited above, the investment banks and hedge funds that survived found that their capital had been seriously eroded by this need to replenish their creditors' collateral. Hence the banks need to be re-capitalized. However, it is not clear that the government should do this re-capitalization through its $700 billion bill. Moreover, the surviving investment banks and hedge funds have realized that such high leverage ratios are not sustainable. So they would like to sell off the mortgage security and pay off some of their borrowings to the pension funds. But since they are all looking to sell off in the short-term, the prices of the mortgage securities are lower, which again requires further de-leveraging. This phenomenon is called the 'paradox of de-leveraging'. However, the real economy on Main Street need not wait for Wall Street to de-leverage. As I mentioned above, the financial meltdown would be avoided with or without the existence of the Wall Street firms. De-leveraging is solely Wall Street's problem, and it is highly unprofessional for Wall Street executives to keep sending out predictions of impending doom in the media.

Q5. Why have the markets for mortgage securities continued to remain illiquid?

A. The main reason that the markets for mortgage securities have been illiquid for a prolonged period of time is that the home-owner who is the only party with a credible and serious interest as a buyer of the mortgage securities has been shut out of the market. Instead of directly involving the home-owner, Wall Street has been peddling bizarre theories of risk management that has resulted in this huge mis-allocation of this $700 billion recently. By providing the information for a direct match-up of the home-owners on Main Street and the security-owners on Wall Street, the government could implement a low-cost eBay-type bidding system that would enable the home-owners to bid for the various tranches in the mortgage securities issued on their homes -- those tranches that the banks want to get rid of. This way the home-owners stand to benefit from a reduction in their debt obligations. The security-owners gets a floor on the prices of the mortgage securities and because of the decent prices, their capital gets replenished. Moreover, the home-owners' debt reduction can be structured in a way that encourages good behavior, and timely re-payment of the rest of the mortgage loan. This process would cost less than $1 billion for the government and achieves the objectives of liquidity and re-capitalization stated in the $700 billion bill. In addition, this direct match-up plan reduces foreclosures by reducing the home-owner's debt. Professor Martin Feldstein has also proposed a plan to reduce foreclosures. In his plan the government re-negotiates the home-owners' loans to provide debt reduction through low-interest loans, in return for enhanced claims on the home-owner. In my plan, the government's role is solely to provide reliable information.

Q6. What exactly is this great innovation of directing accumulated capital towards solving demographic problems that Wall Street has achieved?

A. Throughout history poor people have lived in subsistence conditions. Due to shorter life expectations than exist today, a poor man would have had to work for a living all his life. As mentioned above, the industrial economies of the 19th century Europe enabled the rise of a broad middle class with the means of hereditary wealth transfer and of supporting retired lifestyles. Contemporary times have raised the possibility that this access to wealth of a middle class standard could be further broadened to the whole of the population. Over the course of the 20th century, home-ownership had come to be a fundamental middle class aspiration throughout the world. In his "Lectures on Economic Growth", Professor Robert Lucas cites the travails of the characters in Sir V. S. Naipaul's "A House for Mr. Biswas" as the model for growth and development. Of course, I should also mention that Professor Lucas is more directly concerned with developing human capital rather than with home-ownership in his lectures quoted above.

Historically, massive accumulations of capital that are unrequited, have always been problematic. In addition, accumulation of capital has also resulted in the military-industrial complex. Professor Jeffry Frieden's "Global Capitalism: Its Fall and Rise in the Twentieth Century" is an excellent narration of how promises of global capitalism at the beginning of the 20th century quickly unraveled into the two World Wars. Thus matching the culturally and racially homogeneous retirement age population with the more diverse and younger home-owner population finds a gainful investment for the accumulated capital.

Q7. If Wall Street has been achieving all these great feats, where did it go wrong?

A. When concerns about the mortgage securities surfaced last year, many Wall Street investment firms claimed to be safe because they had not invested in sub-prime mortgages. This created a fear psychosis whence people began to consider these sub-prime mortgages as 'toxic'. The prime mortgage is one which meets the eligibility criterion for purchase by Fannie Mae and Freddie Mac. This includes a 20% down payment and good credit score. Those mortgages that don't meet this criterion were called sub-prime. Gradually, Fannie Mae and Freddie Mac also began to deal with these sub-prime mortgages. So, it didn't make sense to be denigrating sub-prime mortgages. Wall Street wasted a lot of time in late 2007 and early 2008 trying to discredit the sub-prime mortgages. In the modern economy, every single participant is beset with economic insecurity. So, the distinction between the prime and the sub-prime borrower, while it exists, is not really that great. Moreover, it is the sub-prime borrower who stands to gain the most by way of the development of human capital that Professor Lucas discusses in his "Lectures on Economic Growth". So, the sub-prime borrower would be the most willing, in the long-term, to highly value the inter-generational trade of wealth to support the senior citizens. Thus to discredit the sub-prime borrower has been the single major mistake that led to the financial crisis on Wall Street.

Q8. What are the lessons that can be drawn from the current financial crisis for government involvement?

A. Government's role is very important for avoiding crises, like the current one, in the future. The government should ensure that public transportation is available from home-owner colonies to their places of work. Most of the new single family homes are built in colonies of 100 or so, with whole neighbourhoods of new homes developed together. These new home colonies form suburban communities around cities and they are the symbols of affluence near towns. Because of their distance from the business districts, millions of these new home-owners drive their own cars to work. For example, it is not uncommon for software engineers and other professionals living near the Washington beltway to spend two or three hours on the road every working day, by way of commuting to work. Many of these new home colonies do not have frequent public transportation service. If the government would ensure that convenient and timely public transportation to their place of work is available, then this would save billions of dollars in oil expenses for America. Moreover, this way, the automobile would be seen as a luxury product, to be used in the evenings and in the weekends for entertainment, rather than as a necessity to get to work. This way the market for higher-end automobiles would benefit.

For people buying new homes, the government should ensure that they are fully informed about the economic and financial aspects of their investment. Equally importantly, they should not be overloaded with irrelevant, unreliable and unnecessary information. The best step would be ensure that the new home buyers are aware of the Case-Shiller Home Price Index. Currently this index is available only for 20 major American cities, and the data is collected for repeat sale homes, not new homes. But, being aware of this index is the best way new home-owners can be equipped for making financial decisions about their homes. The government should assist the managers of this price index financially so that they can gather empirical data for the prices of homes in all residential communities in America, not just on the 20 major cities. Apart from this, the government should ensure that low income people who are vulnerable to predatory lending are properly educated about the risks involved in sophisticated financial products, like adjustable rate mortgages.

Q9. What is the role of the Chairman of the US Federal Reserve Bank in finding a solution for this crisis?

A. As far as the Federal Reserve Bank is concerned, the most important and pressing need, at present, is for its Chairman, Professor Benjamin Bernanke to give a well-thought public speech that demonstrates that he understands the problems he is encountering in the markets. (I am still studying his speech given at National Association of Business Economists today. I would have more to say after I have studied his speech carefully). He has done a good job in injecting more than $1 trillion into the economy by way of short-term funds to provide liquidity. Moreover, I had given him high marks for his speech at Jackson Hole in August 22, 2008 in my "Update 3: Fire-sales, Bazookas and Hospitals" (dt. 8 Sep., 2008). It still seems that he is the only person in government who is thinking seriously about the current crisis. However, it appears that he has let himself be sidelined by the Secretary of the Treasury, Henry Paulson, who has exacerbated the crisis to global proportions through his Bazooka theory. The best service that Professor Bernanke can do for America is to recommend to the United States Congress that the spending of the $700 billion be postponed by three months.

The Federal Reserve would be well advised to restrict its actions solely to providing liquidity in the global financial system. In particular, changes in the Fed's interest rate are not advisable until a new government is sworn in. In this respect, one should note that one explanation for the persistent spread between the treasury yields and the inter-bank lending rates (TED spread) could be that the private banks, unlike the Fed, are not willing to lend money at real interest rates that are negative. This is a legitimate point, and it suggests that in fact it could be the Federal Reserve that has read the interest rate situation wrong. Then again, buying of commercial paper, as announced today (October 7) is ill-advised. More importantly, it is nearly a dereliction of duty to have approached the United States Congress for permission to spend $700 billion six weeks before a Presidential election. Professor Benjamin Bernanke had disassociated himself from this plan during his Congressional testimony, in fact, going to the extent of saying that he is just a college Professor, and has not worked on Wall Street and does not have any personal connections in the finance industry. The consensus among academic economists (as expressed by Professor Kenneth Rogoff) seems to be that the United States has a lot of money to spend, perhaps referring to the fact that countries in the rest of the world had their currencies seriously devalued in comparable situations like the East Asia crisis, the Russian crisis, Mexican crisis and the Latin American crisis. But, I should point out that $700 billion is about 5% of the annual GDP of the United States.

Q10. What is really ailing the American financial system? Doesn't the government need to intervene to salvage the situation?

A. The real problem is that the common man and the individual investor expect an honest and trust-worthy functioning of government. As I mentioned in my "Update 3: Fire-sales, Bazookas and Hospitals" (dt. 8 Sep., 2008), 'What the taxpayers (and the voters) within the United States, along with investors all over the world, most need to see, at this moment, is that there is a functioning legal (and legitimate) framework within which the financial markets play the role of enabling the process of economic decision-making towards optimal allocations of scarce resources'. At present, decision making at the government level has been taken over by vested interests. Both the Presidential candidates have promised to curtail the greed on Wall Street. The democrats have been complaining about executive compensation for many years now, and they have proposed government regulations of the finance industry in the future. The Republican candidate, Senator John McCain has openly called for the firing of the SEC Chairman Christopher Cox, and for prosecuting any fraudulent activities on Wall Street. This situation has given great jitters to Wall Street. So, the power mandarins on Wall Street have figured that they need to get the most they can before the current administration goes out of office at the end of the year. This seems to be the most credible explanation for their political activities of the last two months. However, I am no expert in political science, and I am just making my own conclusions based on my reading the news. The reader should consult a Political Science Professor on this question. My own point is that the government authorities have very little credibility, especially after the hilarious testimony to the US Congress two weeks ago. What is really ailing the American financial system, it seems to me, is a vacuum in the political leadership. Thus the role of the government in the current financial crisis should be minimized as much as possible until a new government is sworn in. The world runs on democratic principles much more than it does on fear of bazookas.

Although I agree with a lot in this article, I would like to point out that taxpayers have participated on this credit mess too. This is mainly problem of our culture I think. We live today in a World of consuming and speculations wasting our investment without thinking (it is easier of course) except well considered consuming. We should get back to ground. Make, Save, Spend, Invest and Donate in balance.