Government intervention into the market for default credit swaps as recently as 2006 could have helped to improve transparency and stem the uncertainty that has led to the country's recent economic turmoil, according to former treasury secretary Paul O'Neill.
"I think we could have intervened a lot earlier than we ended up intervening," said O'Neill, who spoke at the Clinical and Translational Science conference in Lexington on October 28. "You look at the data in 2006, (and) 30 percent of the mortgages that were written in the first part of that year were no-document, no-down-payment loans, and a very substantial fraction of those - we jokingly called them mortgages - the people were not able to make the first payment. Now, that was a strong enough signal that we should have shut down this idea of flagrant abuse of the ideals and principles of home finance."
In 2006, O'Neill, who was appointed treasury secretary by President George W. Bush in 2001 and resigned in December 2002, floated the idea for a large liquidity pool backed by the Fed and the Treasury to allow mortgage underwriters to recall the increasingly prevalent questionable mortgages and sort them into appropriate risk categories, he said. However, no action was taken.
"If you had ten bottles of water and you were told for sure that one bottle had poison in it but you didn't know which one, you'd stop drinking water," O'Neill explained. "That's basically what happened to us with our financial crisis; people couldn't tell which ones were good and which ones were going to be fatal. So they said, 'I'm not buying any of this stuff,' and the music stopped."
O'Neill, who has been an outspoken critic of the complexity of the nation's tax code, began his career in government service under Nixon and continued under Ford and Reagan before leaving government in '77 to pursue business interests in the private sector. He came to the U.S. Treasury following several years as chairman and CEO of Alcoa. Only months later, 9/11 occurred, triggering a sudden downturn in U.S. economic growth.
While speaking in Lexington, O'Neill shared the following additional thoughts on the country's current economic challenges and the government's response.
The bailout's effectiveness
O'Neill: "We're beginning to see signals that the world financial system is getting on a better financial footing. The thing that is fascinating to me is the unbelievable volatility that we have."
On banks acquiring banks
O'Neill: "I think some consolidation, such as PNC and National City, probably was a useful thing to do, because it wasn't clear that National City could make it on their own. Some of that consolidation makes sense. As long as the mergers create better financial health for the resulting institution, I think that's a beneficial thing to do. On the other hand, I don't think it's a good idea for we the taxpayers to be financing aggressive acquisition."
The derivatives market
O'Neill: "I began to be concerned about the derivative markets in 1991. Henry Kaufman, who was a longtime Wall Street denizen, wrote a book about the emergence of these exotic derivatives and credit instruments that were developing. He made a case that eventually these things were going to get us, because they were so complicated that no one really understood second and third order derivatives. ... Henry Kaufman was pressing that eventually we were going to get into trouble.
"The thing that started all of these things tumbling down was the excess in the housing market. If you say to anybody who knows anything about finance, is it reasonable to give a $300,000 or $400,000 mortgage to someone who doesn't have a steady job and has no income, most people would say that doesn't sound like banking to me. And it's really not banking."
New rules
O'Neill: "I think we should pass a law that makes it illegal in the United States to give someone a mortgage without a 20 percent down payment. ... If you can't afford a home mortgage we shouldn't give you one.
"Similarly, in all of these financial instruments, I think it's important to impose strong reserve requirements so that our financial system is protected from the excesses of an individual player. So if every one of these financial systems had a 20 percent reserve requirement, we would be protected so that even though individual institutions and businesses might fail, the system would not be at risk. I think that's possible to do.
"I'm going to be really worried if the regulatory response is a field army of 100,000 people walking around the landscape trying to make it better. I think if we have clear, relatively simple reserve requirements that will serve us very well."
The presidential election
O'Neill: "Unfortunately, we've gotten to the point where people who want to run for president don't think they can tell the truth and get elected. Ö (A)n awful lot of presidential campaigns now are pandering to the lowest common denominator. They promise people everything. As an example, we the American people now have $53 trillion worth of unfunded liabilities. We, the federal government, keep the books in a funny way so that we only admit to someplace between $10 and $11 trillion worth of debt, but we have obligations that are not funded - that is to say that there are no reserves for them - in the amount of $53 trillion. You haven't heard that from any presidential campaign, including when there were 20 people running for president. None of them dared to mention to the people that we have this enormous overhand of obligations that we haven't done anything about and that we need to do something about."
Another stimulus plan
O'Neill: "It's a dangerous time, because every politician can imagine some additional money that they could put into a package that they believe will help them get reelected. It's like a feeding frenzy. It's almost as though there is no understanding that at the end of the day, we the American people are going to have to pay for this.
"I always find it insulting when I see political people standing up behind a table where the president or governor is signing a bill and act like they're doing us all a favor. If they were sending me their money, I'd like it a lot. They're sending us our money, right? And we're going to have to eventually pay it back, so we're creating an even bigger burden for our children and our grandchildren."
Tax reform
O'Neill: "The U.S Tax Code is 10,000 pages. I'm fond of saying that a 10,000-page tax code is proof positive that we're not an intelligent people. ... We need to do something about that. So what are the candidates talking about? They're talking about more tax credits for one thing or another, tax reductions. Senator Obama even says he's going to raise taxes for 5 percent of the population. But no one is talking about the monumental proof that were stumped. It's terrible."
Our economic future
O'Neill: "I think we will get our financial footing under us and we'll find a bottom to these markets, probably in the next month or two, and then we'll start rebuilding. My greatest fear is that the financial crisis gets translated into the physical goods and services, Ö into the real economy. We already have seen that with housing, and we're seeing it in the automobile sector too, which touches an awful lot of people including here in Kentucky. Toyota has done a great job in the automotive industry, and they will fare better then most, but when you think about coming down from an annual build and sales rate of cars and light trucks in the United States of 17 million to what looks like 13 million for this year - and unless the credit thing gets fixed, it could be even worse then that in 2009 - there are huge consequences for that.
"If you're in the supply chain and you're a supplier to the major players, what looked like a 25 or 30 percent cut in general could end up being a 50 or 60 percent cut for some. ... And that means enormous dislocation with job losses and factory closings. That has a ripple effect back into the retail people, into restaurants, into everything that people buy. So I'm really concerned that the financial thing gets stabilized and that we not lose a lot more jobs so that we can have a reasonable level of demand for products. For housing, it's going to take a couple of years to absorb the overbuilding that occurred during the crazy times. Hopefully, we won't have the same of situation in autos and other major industries."