The Disease of Greed

A Review of John Talbott’s Contagion: The Financial Epidemic That is Sweeping the Global Economy

John Talbott is a former investment banker for Goldman Sachs. For the past decade, he has dedicated himself to full time writing. His book titles include SlaveWages, The Coming Crash in the Housing Market, Where America Went Wrong: And How to Regain her Democratic Ideals, Sell Now!: The End of the Housing Bubble, and Obamanomics.

BY GERMAINE ALITAGTAG

The ongoing financial crisis of 2007-2010, colloquially known as the “Great Recession,” profoundly affected the global economy and the livelihood of individuals across the world. Frequently called the worst economic times since the Great Depression, it is no wonder that the crisis has earned that name. What caused the collapse and how to protect one’s self from it is thoroughly covered in Contagion: The Financial Epidemic That Is Sweeping the Global Economy... and How to Protect Yourself from It by John Talbott.

Contrary to popular belief, the current situation had little to do with Wall Street. It, in fact, started in the American housing Market. Simply put, the “home realtors pushed their clients into ever-bigger homes based on phony high appraisals… that contributed to the dramatic boom in home prices.”1 Deregulation of the market, too, contributed to this boom and its eventual collapse for a good fall could not occur without a rise before it. Starting in the Reagan administration, the economy has undergone rapid deregulation, especially in the housing sector. Accounting for inflation, homes have doubled in price in real dollars. Talbott maintains that such a boom, although not necessarily unsustainable, must be slowed and regulated as it reaches critical levels, otherwise America would experience a severe recession like the one happening right now. Foreign banks with investments in American mortgages and mortgage securities are also brought down. That is not to say that they were not experiencing a mortgage crisis of their own. Countries such as Ireland, the United Kingdom, and Spain saw the same boom in the housing sector and tasted its bite. Since all of their mortgages are floating rate, they see the same increase in mortgage payments as America with its adjustable rate mortgages. Germany, the first country to enter recession, had heavy investments in American mortgages as well as a similar mortgage environment. Even China was not safe from the economic downturn. Its ties to the west are too close as many of the manufacturing and exports China is known for is from American and European corporations. As American and European spending on amenities decline, China’s exporting industry slows. Other factors contributed to this bust, and most of them are due to the mischief of the mortgage agencies and bankers. Essentially, subprime mortgages were given to families with bad credit histories and the vast majority of defaults arose from there. As subprime delinquency rises, prime mortgages are beginning to default and beginning to bring down the economy. Most of the boom occurred in the prime market, making the impact of excessive defaulting that much more damaging to the economy.

Talbot estimates that “home values will deteriorate over the next four to five years” and the economy would not improve until it the housing market hits rock bottom.2 For a long time, homeowners believed that residential real estate was a legitimate investment. This was true in the years before the housing decline because home prices have been moving steadily and even exponentially upward. Since 1981—exactly the year Ronald Reagan took office and introduced deregulation and his own Reaganomics—home prices skyrocketed. By the turn of the century, home prices experienced explosive boom. Now with the housing market in a slump, this is no longer the case. By living in the house, the homeowner is forgoing rental income to live in the property. “So those people who were buying larger and more expensive homes as an investment alternative will now awaken to realize that primary residences are not really investment alternatives at all.”3 While home prices decline, the more recently bought homes go under. However, since homeowners are taking out as much leverage and cash as they can, the amount of cushioning leverage has dwindled and homes are defaulting or entering foreclosure even faster. This housing decline followed a trend reverse of the norm. Up until now, it was a “weak economy and a recession that causes job losses” which in turn force homeowners to default or sell their homes.4 Instead, the housing crisis tumbled the economy and caused a recession, resulting in job loss. Industries relating to housing, such as construction and banking, fell first. Like a tower of jenga, the effective disabling of an entire industry in the web of economy pulled all the other sectors down. In a twist of fate, the current crash is coinciding with the retiring of the Baby Boom Generation. On its own, the retiring of the Baby Boom Generation would have brought economic unrest for years to come; but coupled with the current crisis, national GDP would experience a dramatic hit as the recession is extended even further. Bank losses during the recession prompted the bankers to pull back on all lending to cut losses, furthering the economic crisis even more. It will be years before the banks begin to ease their leverage and to replace their threatened equity capital base. In times of plenty, substantial leverage provides a certain degree of control over the market and is essential for maneuverability; however in times of little, leverage is an enormous financial burden. According to Talbot, the Keynesian Economic Theory is not quite the correct answer. Simply stepping into an economic meltdown and spending monies in an attempt to solve the feedback loop would not accomplish anything because “government spending must be paid for with increased taxes or inflating the currency,” neither of which are very desirable in the current economic climate.5

One of the most massive topics that do not seem to garner as much attention as it warrants is the $400 trillion derivatives market. The derivatives market is “the primary reason the mortgage losses in United States cannot be contained.”6 Adequately explaining derivatives is beyond the scope of this paper, but to put it into layman’s terms, a derivative is a financial contract between two separate entities bounded by an unrelated financial security or asset as collateral. A particularly important sort of contract is the credit default swap. A credit default swap is essentially a special sort of insurance in the event if a third company goes bankrupt. Company X pays Company Y $100,000 a year and Company Y would pay Company X $10 million if the troubled Company Z goes bankrupt. This allows Company X to take a relatively risky debt security with Company Z for $10 million and not face severe consequences. If Company Z goes under, Company X loses the $10 million on the Company Z note but is able to make it whole by receiving $10 million from the credit default swap from Company Y. This is a theoretically perfect system, provided that Company Y could actually pay off Company X in the event that Company Z turns over. In essence, the credit default swap market operates very much like the insurance business. However, unlike the insurance business, the credit default swap market is completely unregulated. In insurance, Individual A pays Company B premiums each year to insure protection from rare, high-cost, low-risk events such as a car crash. The insurance market is heavily regulated so that Company B is legally obligated to be able to pay for such an event, but the same is not true of the credit default swap market. It is exactly because the credit default swap market is unregulated that the housing crisis inflicted such economic devastation. Companies heavily engaged in the credit default swap market that are supposedly “too big to fail” like AIG found themselves in trouble when banks in the mortgage business started failing in quick succession. Due to the financially binding nature of the connections in the network of the credit default swap market and all large companies engage in the market, the failure of large, active players send massive throughout the whole economy. In combination with nontransparent, unregulated hedge funds, the credit default swap market was a recipe for disaster in times of trouble.

What began in the housing collapse and coursed through Wall Street is now whipping back and having dire consequences on Main Street. Banks are beginning to pull credit on credit cards and demanding full restitution, leaving families financially impaired. Industries, now without substantial financing for their credit subsidies, are forced to raise prices and hurt the consumer and sales plummet. Few manufacturing industries were as brutally hit as the American automobile industry. Already not in good shape after losing considerable market share to foreign manufacturers, the recession worsened their condition by reducing their already low credit status and forcing their financing subsidiaries to borrow at higher costs. As the source of credit for American corporations dry up, potential expansion is slowed or even cancelled altogether. This will result in “less consumer demand for [their] products and there will be less perceived need by the company for expanding its products and services.”7 Expansion also includes new jobs for new workers. Unfortunately, a slowing in expansion produces no new workers and may even lay some workers off. However something good may come of this crash, Americans need to learn how to do something they haven’t done in the longest time: save. But how does one save other than simply stuffing the money under the sofa? Although traditionally, housing has been a stable investment, it is now a no-go for reasons obvious. Commons stocks and equities, too, were valid choices, but given the nature of the crisis it also is not a good idea either. For economic times such as now and as well as in any other times of high financial risk, the best investments lie in treasury inflation-protected securities. Treasury inflation protected securities, TIPS for short, “are bonds issued by the U.S. Treasury, which return a modest real return but are augmented by a return exactly equal to whatever the inflation rate is.”8 A second good investment is in slow-to-produce, hard assets such as gold. The third good investment is in any of the BRIC countries. Brazil, Russia, India and China have exhibited substantial growth. Of the four BRIC countries, China is the best bet due to it being the least dependent on banks and commodities. But in the midst of this crisis, what is the government going to do? U.S. Treasury Secretary Henry Paulson proposed a $700 billion plan that passed through congress. $700 billion of taxpayer money will go to pay for risky and discounted mortgages. Unfortunately, the Paulson Plan assumes two false notions: that the current crisis is solely a crisis of liquidity, not capital-loss or bank solvency. The Plan simply creates market where these damaged mortgage goods would just fester and mismanaged banks would sputter around for a time until collapsing again. The problem started with the housing boom and crash, and the reform must start here too. Not all of the reform must come from the Federal government. State and local governments need to crack down on fraudulent activity as well. The housing boom and bust was a result of broken regulation, perhaps America can now learn.

The Great Recession—not referred to as such in Contagion because the name was not invented yet—was fundamentally caused by the American housing market’s boom and bust, according to Talbott. Due to the lax regulation of the housing market as well as the complete lack of regulation of the credit swap market down the road, what could have been a small problem escalated into a global dilemma. Unlike the smaller crashes of the past, this global recession will last seven years at the least. But what does an investor do until then? Talbot recommends investing in low-risk, low-yield treasury inflation-protected securities, hard assets such as gold, and any of the BRIC countries such as China. The problem right now is a “symptom of broken regulatory system that was allowed to fester because of the corruption of corporate lobbying.”9

John Talbott retains a solidly liberal stance on economic policy while interestingly not being a believer in Keynesian Economic Theory. He wrote Contagion just under two years ago, thus adequate analysis of the historiography is near impossible as it falls well in the modern era. However, it is sufficient to say that Barrack Obama’s election definitely had an effect on the writing of Contagion by providing perspective as well as a chance look back to the Bush administration’s performance without prejudice. In fact, Talbott wrote the sleeper hit Obamanomics in which he theorized that Barrack Obama would win the 2008 election and how he will change America’s economic policy.

Reviews of Contagion praise its accuracy and insight. Writer of Obamanomics and Sell Now: The End of the Housing Bubble, Talbott established his reputation of accurately predicting the future; he is “an oracle with a track record” as weekly business magazine Bloomberg Businessweek puts it. He has accurately predicted the election of Barack Obama, the Housing Crash of 2006 and how it would be national in scope unlike the usual local crashes, and even the current recession.9 It is no wonder because Talbott has been billed as a highly accurate predictor of the future. Contagion is no exception to his phenomenal past performance. Talbott enjoys nearly universal praise. Unlike Obamanomics, Contagion hasn’t received as much attention in the media and falls into relative obscurity.

John Talbott accurately forecasted the shifts of the market in the past and Contagion is no exception to that trend. Already many of its prophecies are coming into fruition. He does so with very simple math and puts complex economic concepts such as the derivatives market, AAA insurance securities, and the housing market into layman’s terms. However, the full title of the book is Contagion: The Financial Epidemic That is Sweeping the Global Economy… and How to Protect Yourself from It. It explicitly states “how to save yourself from it” in the title as if it is one of the main selling points. Oddly enough, Contagion doesn’t adequately explain how to protect one’s self in the recession other than which investments are the least profitable and which are the most. This is only applies to investors, economists, and theorists but is of little benefit to the average person struggling to survive in the recession. However, the book does explain a lot on the current crisis and such information could be vitally important to those involved in the industry as well as anyone interested. All in all, Contagion is exceptionally well written.

But how does this all tie into the 1930’s Great Depression? The current recession is essentially caused by the same things as the Great Depression but in reverse. An understanding of the past helps for preparation and planning in the future. The Great Depression, in these economic times, is all the more relevant.

Contagion explains the reasons behind the Great Recession. The intricate economic web, with all its parts melded so intimately together, is very fragile. It is only with stricter legislation and regulation of these markets that the market can actually be considered free. The same happened eighty years ago with the Great Depression. Unregulated markets caused the collapse. Perhaps this time, Americans can learn from their past mistakes. Talbot muses: “if this crisis was a shot across the bow, maybe it will be the clarion call needed to make people rethink how they wish to live their lives.”10

Endnotes

Student Bio

Germaine Alitagtag is a student attending Irvine High. He is enrolled in Advanced Placement United States History for which this book was made. He is a junior and will enroll in Advanced Placement American Government next year. He currently lives in Irvine, California with his family.