A little perspective, please

Three great thinkers - John Steele Gordon, Jeremy Grantham and Diane Swonk - on how bad things are (or aren't) and what might come next.

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Interview by Money Magazine's Janice Revell and Joe Light

Financial historian John Steele Gordon, money manager Jeremy Grantham and economist Diane Swonk
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(Money Magazine) -- How did this crisis happen? Could it get worse? When will the pain end ? If you were looking for answers to those questions - and you should be - you'd seek out someone with knowledge of the past and a record for being right about the future.

Allow us, then, to introduce you to three people rich in both. Diane Swonk, the chief economist of Chicago's Mesirow Financial, has been named one of the country's top forecasters and is an adviser to the Federal Reserve Board.

Jeremy Grantham, co-founder of the investment firm GMO, was one of the first investors to foresee that the financial system was headed for a breakdown.

And market historian John Steele Gordon, whose grandfathers held seats on the New York Stock Exchange, has chronicled America's long history of booms and busts in An Empire of Wealth.

Reporter Joe Light and senior writer Janice Revell spoke with them in mid-September.

In retrospect, there were plenty of signs pointing to the serious and growing problems in the financial system before everything seemed to fall apart at once. Why didn't anyone, on Wall Street or in Washington, take action sooner?

Jeremy Grantham: We got so good at denial. The Fed was in denial, the Treasury was in denial, the bosses of Merrill Lynch and Lehman were in denial. And yet this crisis was the most widely heralded "surprise" in the history of finance - there were plenty of people warning that it was going to happen long before it did.

You were one of them. What did you see that bothered you?

Grantham: All you had to do was open a history book and see what happens when you have a bubble. In this case, there was a bubble in housing and there was a magnificent bubble in risk taking. People were just shoveling their money into risk on the pathetic idea that risk is always rewarded.

That is completely misguided. You don't get rewarded for taking risk; you get rewarded for buying cheap assets. And if the assets you bought got pushed up in price simply because they were risky, then you are not going to be rewarded for taking a risk; you are going to be punished for it.

You can lay the evidence in front of everybody, but they will yawn and ignore it. It's that denial that's impressive. It's what happens in bubbles.

How did individual homeowners contribute to the current meltdown?

Diane Swonk: The housing bubble is certainly the root of the problem in the financial markets. If you were a home buyer, you didn't have to have any skin in the game, you didn't have to put any equity down to get a mortgage.

Another problem is the ease with which people can walk away from their homes in this country. A home buyer can say to a bank, "Here are the keys; the house is your problem now. But I'm going to keep my car, my 401(k) and everything else."

No other major industrialized country in the world allows that. And it encouraged homeowners here to take more risk, to put zero money down.

How much at risk were the financial institutions involved? That is, was this degree of intervention really necessary?

Grantham: Leverage is the ultimate demonstration of risk, and we never had system-wide leverage like this before. Ever. We had several firms that were leveraged 30 to 1. [For every $30 of assets on their books, they put up $1 of equity and borrowed the other $29.] At leverage of 30 to 1, you have to lose only about 3% on your $30 worth of assets and your dollar of equity gets wiped out. You're bankrupt.

Why would those financial firms take on such extreme risk?

Grantham: They believed their risk models, which said they had a diversified portfolio, so their investments couldn't all go down together. And the potential rewards were out of whack with the risk.

Say you're in the hedge fund division of some investment bank and you have a billion dollars to invest. You hit the ball out of the park, make 120% on that billion and probably walk away with a $45 million bonus. If you lose the billion dollars, you're fired. Hey, that's not bad! If I thought the odds of success were fifty-fifty, I'd be a fool not to try.

How bad is our current situation compared with previous financial crises?

John Steele Gordon: It feels bad but not like a panic. In a classic panic, as in 1987 or 1929, everyone was selling and prices went through the floor. The market lost 22% on Oct. 19, 1987, compared with 4% on the day Lehman filed for bankruptcy. We were getting close to a breakdown in the whole financial system, but now that decisive government actions are being taken, we're stepping back from the brink.

By comparison, after the 1929 stock market crash, the government didn't do much of anything - and what they did do just made the situation worse. For instance, the Fed kept interest rates high and the government implemented the largest tariff in American history, which was effectively a big tax increase in a declining economy. These things converted a perfectly ordinary recession and market crash into the greatest economic calamity in American history.

In 1987, on the other hand, it was the Federal Reserve that ended the panic. The Fed basically called up Wall Street and said, "Listen, you guys need liquidity. Bring your wheelbarrows and we'll fill them up." We've seen a similar use of the Fed in the current crisis.

How have other countries responded to the deteriorating situation here?

Swonk: This is one aspect of the crisis that most people aren't talking about. The financial liquidity that has been infused into the market to provide stability has come not only from the Federal Reserve but from international sources as well. The European Central Bank and the Bank of Japan have been very involved.

The reality is setting in that globalization has made us all intrinsically linked, and coordination of policy across borders is critical. That is not the place America was in during the Great Depression. Then the rest of the world was still hurting financially from World War I and there was nowhere to go outside the U.S. to raise money. Today there are a lot of places to go.

Is a massive government rescue program really necessary?

Swonk: The piecemeal approach to creating some sort of backstop to the financial system - Bear Stearns, AIG and so on - appeared to add more panic than confidence to the markets. We needed a more holistic approach to stop the bloodletting, especially once it started to affect short-term credit.

What about the cost to taxpayers?

Gordon: People thought the cost associated with the S&L crisis would be two or three times larger than the $150 billion it turned out to be. At the time the S&L's problem assets - real estate - would have overwhelmed the market if sold at once. The government later sold them for much more than people originally thought they could. That may also be the case today.

We've now seen huge banks acquire other huge banks. Are these massive financial institutions dangerous?

Gordon: It's good because it makes the banks more stable. A lot of the banking problems we had earlier in our history occurred because the banks were so small. In 1920 we had 30,000 banks in this country; each small town had its own bank. If the economy of that small town went into the toilet - a factory closed or there was a long drought - the bank went broke because there was such a small base supporting it.

The more widespread a bank is, the more stable it is. If something goes wrong in one area, there are other places where things are going well to offset that.

What can the past tell us about where the stock market is going next?

Grantham: Historically, when a market bubble has popped, it has almost always overcorrected. But after the tech bubble burst in 2000, the stock market didn't hit the lows it should have.

Before it could, the housing bubble and tax cuts that followed 9/11 kicked off the biggest sucker rally in history, from 2002 to 2006. So I think the market isn't cheap yet. There is more pain coming. I don't think we'll hit the low until 2010.

Swonk: But even though the market is turbulent and scary today, we're still looking at a pretty favorable environment over the longer term for stocks. Productivity growth is accelerating - we all know this, of course, because we're working harder for less money. Rising productivity leads to rising corporate profits. That, historically, has been highly correlated with a bull market.

What's your advice to investors now?

Grantham: Understand that the market may recover for a while and then go to a new low. One of the lessons I have learned over the years is that things can get a whole lot more extreme, both up and down, than you ever dreamed of. So we may drop another 30% before we hit bottom.

Keep telling yourself every night that you're a long-term investor and don't look at daily stock prices. And it's not too late to shift some of your money to high-quality blue chips. Emerging markets are probably no longer too expensive either. If you had 80% of your stockholdings in blue chips and 20% in emerging markets, you'd have a pretty reasonable portfolio to ride out the bad times.

Gordon: Psychology is central in these kinds of markets. Don't panic, that's the No. 1 rule, and think long term.

What's ahead for the economy now?

Swonk: We can't really avoid the economy getting worse before it gets better. We don't have the tax rebates helping us out anymore. Labor markets have deteriorated further, and people who are working are in many cases earning less. So I don't think we'll recover before 2010. It won't be until then that housing prices stabilize, and that's the key issue.

I'm confident that they will by 2010 because we are still creating a million new households a year and those people have to live somewhere. We've got some fundamentals working for us, but it will take a while to get there.

What needs to change to prevent another crisis from happening?

Gordon: We need a thorough housecleaning of the financial regulation system. Right now it isn't even really a system. It just sort of grew over the years and doesn't make a whole lot of sense.

You have the Federal Reserve, the Comptroller of the Currency, the FDIC, the SEC, state banking authorities and state insurance authorities - and all of them working at cross-purposes. It doesn't make any sense at all anymore.

Is there a silver lining to all of this ?

Grantham: People lost the knack of thinking that cheaper assets are better. We're going to return to that way of thinking, and that's incredibly good news.

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