Once Upon a Time on Wall Street…

I thought I’d let the professionals tell you a little bedtime story. Things in our economy ain’t looking so hot right now, and stand to get worse before they ever get better, especially what with all the cooks in DC sticking their fingers in the soup.

So here’s the story, told with their words.  We join our tale just as the ties that bind up the golden kingdom are starting to fray and break…

[Chapter One]

Threatened by a “financial tsunami,” the world must consider building a financial order no longer dependent on the United States, a leading Chinese state newspaper said on Wednesday.

The commentary in the overseas edition of the People’s Daily said the collapse of Lehman Brothers Holdings Inc “may augur an even larger impending global ‘financial tsunami’.”

[…]

China’s central bank earlier this week cut its lending rate for the first time in six years, a move analysts said was aimed at bolstering the economy and the battered stock market.

“The eruption of the U.S. sub-prime crisis has exposed massive loopholes in the United States’ financial oversight and supervision,” writes the commentator, Shi Jianxun.

“The world urgently needs to create a diversified currency and financial system and fair and just financial order that is not dependent on the United States.”

[Chapter Two]

Henry Paulson and Ben Bernanke have saved us, for now, from a market meltdown – but at the cost of allowing the folks who caused the current crisis to keep ducking reality.

In the long run, guess who gets to bear that cost?

The Treasury secretary and Federal Reserve chairman have spent September dashing off blank check after blank check in a bid to quell turbulent markets. Since Sept. 5, the feds have pledged $200 billion to shore up mortgage giants Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), $85 billion to prop up insurer AIG (AIG, Fortune 500), and $50 billion to guarantee money-market funds.

Then there are the untold sums the U.S. might spend under the plan Paulson unveiled Friday to set up a bad bank to relieve institutions of their troubled mortgage assets. And let’s not forget the hundreds of billions the Fed has poured into the markets in the name of maintaining liquidity.

Even in a U.S. economy that produces $14 trillion worth of goods and services a year, that’s a lot of cash.

Spending all that money, sooner or later, will intensify long-standing questions about the nation’s fiscal health, possibly at the expense of another drop in the value of the dollar.

“We’re going to be sorting this out for years,” says Howard Simons, a strategist at Bianco Research in Chicago who questions the blitz of taxpayer spending on programs that haven’t even been debated in Congress.

Ultimately, what could prove to be the most expensive aspect of the bailout spree is the message the government is sending to firms in which the market has lost confidence. Prudent management, it seems, will be punished, while the status quo – however unhealthy – must be maintained at all costs.

The strong stock-market rally of the past two days aside, intervention that fails to foster a shakeout of weaker firms will only delay the reckoning that must occur before a sustainable economic recovery can take shape.

[Chapter Three]

Bank lobbying groups, saying U.S. accounting policies are helping to deepen the financial crisis, asked Congress and regulators to suspend rules that force companies to put a price on their difficult-to-value assets.

“We are suggesting that the SEC issue a temporary order to negate the negative impact” of the so-called fair-value rule when the economy slumps, Scott Talbott, senior vice president of government affairs at the Washington-based Financial Services Roundtable, said in an e-mail.

Companies including American International Group Inc., which accepted $85 billion in a U.S. takeover, have said rules set by the U.S. Financial Accounting Standards Board require them to record losses they don’t expect to incur. Banks and other financial service companies have reported more than $520 billion in writedowns and credit losses since last year.

[…]

Supporters of fair-value pricing say it adds to transparency and gives investors more information about publicly traded companies.

“This is really just an old conflict between management, which wants to control volatility, and investors, who want transparency,” said former FASB member Donald Young, who left the board in June. Companies are “blaming fair value and using the crisis for cover.”

[Chapter Four]

In recent times, investors have typically gotten rich in our society by betting on the rich to get richer. And most of the time, that’s what happens: the rich get richer. Every so often, however, we have a meltdown because, during the bubble, investors temporarily overestimated the rate at which the rich will get richer—e.g., Silicon Valley in 2000, the Texas oil patch in 1982, commercial real estate developers around 1990, and so forth.

But, most of the time, you can get richer betting on the rich to get richer.

[…]

The homeownership rate had been stuck at about 64% since the late 1960s. The Clinton and Bush administrations pushed hard to get it up to 68-69%.

What in the world made anybody think that the second quartile up from the bottom was developing more earning capacity?

They’d sent their wives out to work a couple of decades before. What could they do now to pay bigger mortgage payments in the future?

[…]

So, let’s say that big stars’ homes in the Hollywood Hills go for a median of $11 or 12 million. In the spring of 2006, the median sales price of all homes (houses and condos) in the Los Angeles region, an urban area of about 5 million people that includes vast tracts of Nowheresville in South Central and the San Fernando Valley, was $580,000. (It’s now just under $400,000). So the ratio of home prices for stars to nobodies was about 20 to 1.

Now, 20 to 1 sounds like a big difference. But most measures of ability to pay would favor stars over nobodies by much more than 20 to 1.

Consider net worth outside of home equity. I would guess that most people who take out a $10 million mortgage might have, say, $10 million in stocks, bonds, CDs, art, vintage cars, and other assets, for a 1 to 1 ratio. What was the net worth of the median buyer of a $580,000 home with almost zero down payment in LA in 2006? $58,000? Maybe not that much when you subtract the car loans and outstanding credit card debt.

If the median net worth was $58,000, that’s a ten to 1 ratio between mortgage and net worth (heck, there were buyers in 2006 and 2007 who had a net worth consisting of a monthly bus pass and some lottery tickets, so their ratio was close to infinite) vs. 1 to 1 for the rich folks.

Obviously, I just made most of these numbers up. But I know that I at least got the sign right. So how did people not notice that financial institutions were making huge bets on something that just wasn’t happening—the lower middle of society getting much better off economically?

(And don’t tell me about how much cheaper DVD players have gotten. I’m not talking about standard of living, I’m talking about ability to pay debt obligations.)

That level of stupidity requires a bipartisan consensus on what you aren’t allowed to talk about in public.

[All links in original]

We’ll continue this story tomorrow night.  Sleep tight.