The subprime paper that eventually collapsed found its way onto the balance sheets of many banks, funds, and other firms. Had “the securities initially received the risky ratings” they deserved (and many now carry), the various pension funds, trusts, and mutual funds that now own them “would have been barred by their own rules from buying them.”

Nobel laureate Joseph Stiglitz, economics professor at Columbia University, observed:

“I view the ratings agencies as one of the key culprits. They were the party that performed that alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies.”

In 2008, the House Oversight Committee opened a probe into the role of the bond-rating agencies in the credit crisis, and Congress held a hearing on the subject, featuring a now-infamous instant message exchange: “We rate every deal,” one Standard & Poor’s analyst told another who dared to question the validity of the ratings process. “It could be structured by cows and we would rate it.”

When they are not rating bovine structured products, the rating agencies can be found belatedly downgrading junk paper into bankruptcy. In March 2009, Moody’s Investors Service came out with a new ratings list: The Bottom Rung.

“Moody’s estimates about 45% of the Bottom Rung companies will default in the next year,” The Wall Street Journal reported. Perhaps the clichZˇ about analysts is better applied to rating agencies: You don’t need them in a bull market, and you don’t want them in a bear market.

While it was the investment banks that sold the junk paper, it was the rating agencies that tarted up the bonds. It was the equivalent of putting lipstick on a pig: This paper could never have danced its way onto the laps of so many drooling buyers without the rating agencies’ imprimatur of triple-A respectability.

Yet considering the massive damage they are directly responsible for, the rating agencies have all escaped relatively unscathed. Given their key role in the crisis-were they corrupt or incompetent or both?-one might have thought an Arthur Andersen-like demise was a distinct possibility. Warren Buffett should consider himself lucky-he is the biggest shareholder of Moody’s, and is fortunate the scandal hasn’t tarnished his reputation.

Of course, none of this would really have mattered if a few hedge funds and a much larger number of institutional investors-including foreign central banks-didn’t suck up so much of this suspect paper (China evidently bought $10 billion in subprime mortgages). Through the indiscriminate use of leverage and by failing to know what they owned, the purchasers of the triple-A-rated junk paper must also shoulder some of the blame.

How did so much of the investment world manage to overlook these issues? Didn’t anyone do any due diligence? Or was it simply a case of the casinos keeping the securitization process rolling? I’ve had conversations with CDO originators and insiders, as well as money managers, who unabashedly claimed: “We knew we were buying time bombs.”

So we can rule out sheer ignorance. Rather, it appears that as long as deal fees could be generated, Wall Street kept the CDO factories running 24/7.

Talk about your misplaced compensation incentives. This is precisely the kind of self-destruction that Alan Greenspan believed was impossible in a free market system. The flaw he misunderstood was simply this: It wasn’t that the free market would prevent it from occurring; it was that relentless competitive forces would drive such firms out of business. That is what began to happen in 2008. The free market actually worked as it should-firms that managed risk poorly were demolished by market forces. The trouble was, none of the erstwhile free market advocates had the stomach to live through the creative destruction Mr. Market was serving.

That is the risk that excessive deregulation brings: We can eliminate regulations that might prevent systemic risk. However, the free market advocates whine when the market doesn’t do their bidding. Bad choices by management led to failure. That failure brought on a global recession, bankrupted over 300 US mortgage companies, and turned many of the biggest banks and investment firms into tapioca.

The firms that allowed excessive risk taking and leverage found themselves on the wrong side of the corporate version of Darwin’s laws-which was precisely where they belonged.

Several of the states with the biggest foreclosure problem today had an opportunity to confront the problem when it was much smaller. These are the states that now lead the nation in foreclosures. Their regulatory agencies had long lists of complaints brought to their attention. None acted upon them.

A 2008 expose by the Miami Herald revealed that Florida allowed thousands of ex-cons, many with criminal records for fraud, to work unlicensed as loan originators. More than half the people who wrote mortgages in Florida during that period were not subject to any criminal background check. Despite repeated pleas from industry leaders to screen them, Florida regulators refused.

And in California, attempts to regulate the many subprime mortgage lenders working in the state were beaten back, primarily by Democratic lawmakers who were protecting the then fast-growing industry.

Today, California and Florida are the nation’s leading foreclosure factories.

Then there is Arizona. When Internet real estate service Zillow began publishing online housing price estimates in the state, it received a cease and desist order from the Arizona Board of Appraisal. Zillow’s site makes it clear that its data are merely estimates and not actual appraisals. Regardless, misguided Arizona pols did not want some online firm horning in on their local business. It is no wonder Arizona is ranked fourth in the nation in terms of defaults and foreclosures listed by RealtyTrac.

The misguided deification of markets is the primary factor that led us to being a Bailout Nation. Markets can and do get it wrong-not by just a little, either; occasionally they can be wildly wrong.

Recall those two Bear Stearns hedge funds that blew up in June 2007. The S&P 500 stumbled in August 2007 at that early sign of a brewing credit crisis. But in the market’s infinite wisdom, it determined that credit wasn’t such a significant problem after all. The S&P 500 and Dow Jones Industrial Average proceeded to set all-time highs a few months later, peaking in October 2007. That they got cut in half over the next year makes one wonder why anyone would call the stock market prescient.

This was not the only time Mr. Market has managed to get things precisely wrong. There are far too many examples to enumerate here.

In the final analysis, allowing markets to set policy is inherently antidemocratic. Free people are entitled to elect a representative government, which then enacts legislation on their behalf. Those elected representatives go to Washington, D.C., to do the people’s will. If it is the people’s will to prevent testosterone-addled traders from saddling the taxpayers with trillions in losses, that is their choice.

Americans have long recognized the advantages of economic freedom. We want the markets to be relatively free to operate. However, we do not want to allow the worst of human behaviors to have free rein. Complaints about regulating markets are actually objections to proscribing the worst behaviors of the people who operate in those markets. We want markets to operate intelligently, but not run roughshod over us. Blame the radical free-market extremists who insist on replacing representative government with the so-called wisdom of markets. This has proven to be misguided.

What the actual result of market-based decision making does is to eliminate those pesky human voters from exercising their will through a representative government. Ultimately, the free-market zealots are not only antiregulation, they are antidemocracy and antirepresentative government. Taken to illogical extremes, they would create a market-based dictatorship.

One part bad philosophy, one part mob rule. That pretty much sums up the financial markets, circa 2008-2009.

Casting Blame, Part II originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

There are many who were rooting for the blame to be assessed to a given political party, a particular player, or a specific act of malfeasance. In reality, the situation is far more complex. The responsibility is widespread, and there is plenty of shared blame. Joseph Stiglitz, the Nobel Prize–winning professor of economics at Columbia University, called it a “system failure”—not merely one bad decision, but a cascade of many decisions that produced tragic results.

The recklessness and incompetence seemed to be a team effort. With no single villain and so much blame to go around, I fear missing some person or event that significantly contributed to the mess now enveloping the global economy.

That does not mean we cannot attempt to highlight those whose contributions have disproportionately led to the final catastrophe. After exhaustively reviewing this debacle, I assess responsibility in order of culpability as follows:

Many of the monetary and regulatory errors that directly led to the present crisis are attributable to the man they once called the Maestro. Under the guidance of Alan Greenspan, the Federal Reserve abused monetary policy, ignored critical lending issues, and failed to regulate new and irresponsible banking products.

Several of Greenspan’s policies proved to be wildly misguided: the regular interventions to protect asset prices and bail out investors, the irresponsibly low rates after the post-2000 crash, and his nonfeasance in supervising lending. Most of all, it was his deeply held philosophical conviction that all regulations are bad, and are to be avoided at all cost. We now know what that cost is, and it’s astronomical.

Alan Greenspan had spent his years at the Fed operating under an enormous philosophical misconception, as the former Fed chairman admitted in testimony before Congress on October 22, 2008: “I made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such as that they were capable of protecting their own shareholders.”

Based on Greenspan’s worldview, the events of the present crisis and many others that occurred over the past decade were impossible, given that the so-called wisdom of the free markets would prevent them. Only they did occur. Greenspan’s faith was wildly misplaced, and the taxpayers are that much poorer for it. If we have to put our finger on the single intellectual flaw that underlies the housing collapse, the credit crisis, the economic recession, and the problems with toxic paper, it would be a misplaced belief that markets could self-regulate. One is reminded of the Benjamin Disraeli quote: “He was distinguished for ignorance; for he had only one idea, and that was wrong.”

Given how enamored Greenspan was of free markets, it is increasingly difficult to reconcile many of the actions he undertook. The very concept of the champion of free markets repeatedly intervening in their inner workings is a contradiction of enormous proportions. It is a catch-22 worthy of Joseph Heller.

It is beyond my capacity to decipher how Greenspan justified his internal conflicts, but at least he later admitted that his primary philosophy “had a flaw.” Unfortunately, his flawed economic belief system colored nearly every policy he enacted as Federal Reserve chairman. Most of today’s crises trace their roots in part to his policies.

In 1836, Mayer Rothschild wrote, “Give me control of a nation’s money, and I care not who makes the laws.” If only that prescient warning had been heeded by the Federal Reserve. It might also serve as an admonition for Ben Bernanke, the current Fed chief.

The Greenspan era lasted 20 years (1987 to 2006). The Federal Open Market Committee (FOMC) must take responsibility for following him so obsequiously, especially in the latter years of his reign. Exceptions include Edward Gramlich, whose timely warnings about subprime and early concern with predatory lending were on target and ignored. So, too, William Poole deserves credit for his many cautionary warnings about the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. To our chagrin, neither man was paid much heed by Greenspan or the FOMC.

The single biggest fault found within the Fed is its inability to fulfill its responsibilities as bank regulator. The Fed not only failed to supervise lending institutions, but it also ignored the most significant shift in lending standards in the history of human finance. The results were disastrous.

The Fed, as an institution, failed the nation. It directly encouraged mass speculation. It failed to supervise innovative new forms of lending. The inflationary spiral that sent oil soaring from $16 in 2001 to $147 per barrel seven years later, along with other commodity and food prices, is attributable to its radical rate-cutting regime.

The current chairman, Ben Bernanke, deserves partial blame for the Fed’s slumber during this inflationary spike. A renowned student of the Great Depression, it was then Fed Governor Bernanke who raised warning flags about deflation after the tech bubble burst. He provided the framework and intellectual cover for Greenspan’s ultra-easy money circa 2001 to 2003.

As Fed chair, Bernanke was terribly slow to realize the subprime mortgage crisis was anything but “contained.” By the time he did awaken to the crisis in August 2007, he responded with a series of programs that pushed the envelope of legality, dramatically expanded the Fed’s balance sheet, and put the central bank’s credibility at risk.

Of all the institutions that played a part in the current crisis, none had a more prominent role than the Federal Reserve.

The first telegraph message ever sent, “What hath God wrought,” reflected Samuel Morse’s deep concern for the repercussions of his own actions. If only Phil Gramm were so similarly introspective.

While Congress deserves much blame for the crisis, no one elected official looms larger in our drama than Gramm. He was the senator behind the Commodity Futures Modernization Act of 2000 (CFMA), and spearheaded the repeal of Glass-Steagall. The legislation that overturned it bears his name (Gramm-Leach-Bliley Act).Both legislative acts were WMDs—weapons of monetary destruction. These time bombs eventually led to mass financial destruction.
Barbara Roper, director of investor protection for the Consumer Federation of America, said: “Since the financial meltdown, people have been asking, ‘Where was Congress? Why didn’t they see this coming? Why didn’t they provide better oversight?’” We now know the answer is that members of Congress were too busy pursuing a radical deregulatory agenda. Instead of protecting investors and defending the overall economic system, their misplaced concern was how to make life easier for Wall Street.

During the late-1990s era of deregulatory dogma, the GOP controlled the House and Senate, and Gramm was the point man on issues of deregulation. The Texas Republican was aided in his deregulatory quest in part by Senator Chuck Schumer, a New York Democrat. Perhaps Schumer represented the interests of New York’s Wall Street too well.

To this day, Gramm still claims deregulation had no impact on the housing collapse or the credit crisis. The exempting of derivatives from all regulation—including state insurance supervision, reserve requirements, or clearing information—was not at all related to the eventual problems, according to Gramm. He remains unrepentant as to his impact. Placing any blame on deregulation was simply “an emerging myth,” the retired Texas senator has said. Deregulation “played virtually no role” in the economic turmoil engulfing the globe, Gramm claimed in November 2008.

What shameless nonsense. You will not come across a greater example of cognitive dissonance in your lifetime. Gramm’s inability to recognize the results of his legislative handiwork is a function of a flawed mind protecting itself from the harsh reality. The inconsistency of his deeply held philosophy and the results thereof are logically incomprehensible to Gramm’s conflicted brain. If he were ever to admit the truth, he would likely go stark, raving mad.

I’ll give Alan Greenspan this much credit: At least he has come clean about the “flaw” in his philosophy. Gramm, by contrast, remains committed to his tainted brand of unregulated, free-market absolutism. Of all the players in the tragic drama that has unfolded, he alone remains unrepentant. Gramm is Bailout Nation’s most intellectually bankrupt citizen. Like Greenspan, Gramm had only one idea; unlike Greenspan, he had no comprehension it was wrong.

Barry Ritholtz
for The Daily Reckoning

Casting Blame, Part I originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

But that’s a touch of an exaggeration. What it really means is that U.S. consumers are going to engage in less-conspicuous consumption than they used to. The days of consumers making up 70% of US GDP are likely to fade. I expect to see the economy move back toward consumers being 65% — a sustainable level that existed prior to the credit and housing boom of the 2000s.

Out goes the conspicuous consumption of the 1990s and 2000s… Lean and green is in; grotesque and self-indulgent are out. Downsize that McMansion! Replace the SUV with something fuel-efficient! Save, instead of consuming!

This is much more than a philosophical view — it’s what all of the economic data over the past year have been practically screaming.

This will have a significant impact on the overall economy. And businesses are going to have to pick up some of the slack. Capital expenditures are going to have to do their part as the balance between consumer and business consumption reverts to more normalized ratios.

The present environment makes it likely that businesses will focus on investments that can pay for themselves quickly. That means expenditures on items like business intelligence software, ways to become more energy efficient, and the like.

But that’s just guesswork. In terms of actual data, here is what the new, leaner American economy looks like:

• Asset Deflation: Equity portfolios are on average down about 40%. Dividends are being slashed, stock repurchases canceled. Even with the recent rally, stocks are off more than 40% from their peaks. And on a national basis, home prices are down 25%

• Consumer Spending: Down significantly, after the US had its worst Christmas retail selling season in 40 years. The paradox of thrift — people saving at a time when the economy needs them to spend — has turned the savings rate positive. Conspicuous consumer consumption has been replaced with conscious capital conservation

• Retail Stores: Have been extremely hard hit. Many of the big chains are filing bankruptcy like Circuit City, Linens ‘n Things, The Sharper Image, Steve & Barry’s, Tweeter, Mervyns, and Fortunoff. The survivors like Starbucks, Macy’s, Sears, and Office Depot are closing stores left and right. In many cases, the surviving chains will see as many as 10-20% or more of their existing stores close. By the time we finally emerge from this recession in 2010, retail shopping will have a much smaller footprint than before

• Employment: Over 4 million jobs lost already, with anywhere from 2-4 million more to go, the work force and labor pool are also being downsized. Unemployment broke through 25-year highs, to tag 8.1% last month. U-6, the broadest reading of unemployment (including part-time underemployment), was just under 15% in February; this is the highest reading in decades.

The only age cohort seeing employment gains is the 55-plus group. This is due to their ugly realization that the market collapse means they cannot retire. Hence, it’s back to work for the silvered-hair crowd

• Finance & Wall Street: The Street has been hard hit — look for much smaller revenue, with staff cuts of 25-35%. The asset managers that get paid a percentage of assets under management have seen the value of their assets drop 45-50% — and with that comes a revenue drop of the same percentage. Who are the safest players? Those with green profit and losses, and/or substantial assets under management. And who is at risk, besides finance employees? Everyone else

• Autos: US auto sales have simply plunged. Annual sales are down 37-50%, depending upon the nameplate — from an annual US rate of 15 million to barely 10 million cars per year. Its not just Detroit, either — Toyota, Honda, BMW, Lexus, Nissan, and Mercedes are also suffering

• University Endowments: The intellectual engine of America’s brain trust has just taken an enormous hit to the frontal lobe: Harvard, Yale, Stanford, MIT, and others are down 25-30%-plus over the past 6 months alone. These big endowments fund professorships, grants, student scholarships, and pure research. The loss will be deeply felt over ensuing years, and even decades

• Wages: US wages have been punished by globalization. They have been stagnant over the past 10 years. We are likely to see contractions in wages over the next 1-2 years or longer. This is consistent with our thesis of the downsizing of the US consumer

• Media: Circulation and advertising dollars at major newspapers are falling. It’s likely that 50% of print newspapers will be gone, or web only, in 5 years. The Seattle Post-Intelligencer just went web only, the biggest such paper to do so yet. Will Fox Business channel, which launched at the peak of the stock market in 2007, manage to survive this onslaught? I’d say it’s less than even money

• Pharmaceuticals: We witnessed huge 15-20% R&D cuts at several major pharmas (Pfizer’s huge research layoffs most recently). That means staff cuts also. This doesn’t bode well for new drug development and cures; the misallocated resources over the past decade have led to lots of dead ends. I expect to see a lot more consolidation in the pharma area, and more mergers between pharma and biotechs.

What is the sum total of all this? US GDP will contract 5-7% in 2009 Q1 and Q2, 2-4% in the second half of 2009, and will flatten in 2010. Back in 2001, we forecast the US economy could hit $15 trillion by 2010-11; that now gets pushed back to 2015-17.

There is a silver lining to all of this: First, the unhealthy reliance on credit seems to be going away. We cannot grow by borrowing and spending — but we can grow by producing and spending.

Second, the massive misallocation of capital in society has also been revealed. Out goes financial engineering, in comes making money the old-fashioned way — earning it.

Lastly, for those of you who managed to avoid the worst of the bloodshed — you may have moved to cash in early 2008 or (God bless) you were short for some of the run downward — this is a “target-rich environment.” Whether you are looking for value stocks, artwork, rare collectible automobiles, or vacation properties — there is many a deal to be had.

Those contractors who didn’t return your calls in 2005? They are begging for work. Toxic paper at 10-20 cents on the dollar ain’t all that toxic. And the owner of that 40-foot sports cruiser who can’t make payments is a motivated seller.

Note that this isn’t being heartless or greedy. Recessions end when values become so compelling that activity begins to pick up. We are not quite there yet, but we are much closer than we were a year ago.

Distressed sales create opportunities for the cash-rich buyer who was cool enough not to chase the top or get panicked at the bottom. Make a low-ball offer and see what comes of it.

Who knows, you might even help turn the economy.

Downsizing America originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.