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March 19, 2008

Pushing on a String of Discontent: Bernanke's Tale

Even as this winter pushes into Spring there is little bright to see other than the buds of crocuses and daffodils pushing their way through the soil here in Washington. A few days ago a group of top drawer Wall Street executives while testifying before a Congressional committee were asked why they should be pulling in such unwieldy pay checks even as their banks go cup in hand to the United Arab Emirates, Dubai, China and Singapore looking to sell of chunks of their businesses for the capital needed to pay off their blockbuster follies of the last few years. Their response:  "But, look at the big profits we rolled up for our stockholders just a few years ago."

In other words, while we were staging this most excellent pyramid game, no one complained about a hundred million here or there, not even our stockholders; so now why shouldn't we be paid a little extra for managing the hard times we are going through? In effect, "you really want to know where the bodies are buried, then get real!"

But for just a moment, never mind the titans at the top of the world, that mentality works on regional levels as well.  Here in Washington, a local marvel at the crest of another bubble when the capitol region was fast becoming a tech Mecca, Friedman, Billings, Ramsey, or FBR as it's known, have been on a nearly consistent losing streak that has seen practically every investment they've undertaken this millennium, lose money. Just recently their board announced that they (the founders) were awarding their top executives (themselves) a massive bonus-- one supposes to keep themselves in place so they can do even more damage.

Here's what Steven Pearlstein, a columnist at the Washington Post had to say on that account in his Friday column:

"But for pure chutzpah, nothing tops the recent announcement that, following a year in which the company posted an operating loss of $740 million, Billings and three other top executives were awarded bonuses and stock grants worth $30 million, at the time equal to nearly 9 percent of FBR's market value."

The Ultimate Bear Trap

But, of course, last Friday was different. it marked a clear point of demarcation, as the government moved from mere propping and backstopping to the next big step in this menacing financial unraveling. Friday saw hundreds of billions pledged for the first phase of a pure and simple bail-out for one of Wall Streets bare knuckle gangs. The Fed was now taking mortgage backed securities no one else wanted as loan collateral, albeit for 28 day loans, not for a commercial bank, as comes under its mandate, but instead to ward off the collapse of a brokerage and trading business that specialized in mortgage-back finance.

As you no doubt remember there was an incident back last summer when a couple of hedge funds managed by Bear Stearns -- Wall Street's fifth largest investment and clearing businesses-- that had borrowed large sums of money to invest in (actually, soak up paper sitting on Bear's books) mortgage-backed securities, ran into a reef.  See our piece, The Big Crack

It was the first major extrinsic sign that the great easy money home lending bubble was about to burst.  Of course, anybody looking should have foreseen this outcome as the pyramid scheme finally ran out of suckers, in this case some of Bear Stearns own high worth customers.

Every so often there comes a point when a downdraft causes Wall Street and Main Street to collide: right then down on Main Street people's wages were standing still even while they were gobbling up high priced homes for themselves that had doubled or trebled in price over the course of a few short years.  The easy lending had also fostered a pack of players looking to "buy" (no money down, no questions asked) and flip neighboring properties as they came on line. And if you wanted to know how, all you had to do is look at the ads in your local paper or even check your mail every day. There was no shortage of banks and brokers who were bending over backwards to lend you money against the accrued value in your own house as they urged you to buy a newer, bigger one.

But never mind the collateral, the money kept getting easier: first, you didn't need any money down, so you could borrow up to 100% or the purchase price, then you didn't need to pay back any of the principal, then not even at the going opening mortgage rate for the first couple of years and finally, you only had to pay off the teaser interest part of the loan.  Finally, the word got out that you didn't really need to prove you had a job or reliable income to get a loan, you could just make up an income figure and move the family into your Mac-mansion as fast as you might get a pizza delivered there.

The Huge Sucking Sound from Wall Street

There was, it seemed, an uncannily huge demand to underwrite these mortgages no matter what shape or form they came in, and it came all the way from the heights of Wall Street. For, with the ink still wet on the loans, they'd be immediately taken off the hands of the issuing banks and, with a special kind of magic known only to these financial wizards, crammed into some three-letter financial gadget (ABS, SIV, CBO, CLS)  that would pack them together with a mix of other peoples' loans, and send them off as fodder for this new, largely unregulated and soon-to-become massive, shadow banking system.

The Fed's easy money policies, laissez faire attitude and the tsunami of new dollars being created by trade-deficit recycling, had, it seems, been turned into a great demand for paper that paid even just a percent or two more than the safe stuff and so a profitable bundling business turned into profitable underwriting businesses and bundles were sliced, diced and rebundled in secondary and tertiary derivative markets and sold to anyone who wanted to lay down cash or step up to the window and borrow to leverage their bets. Investors around the world were rushing into the hedge funds that were pulling off these tricks, ready to pay the fund managers up to a third of the paper profits in fees for the privilege.

At the end, there was even a perverse echo of the previous bubble, the hedge fund doing an IPO; cherry on the cake: to leveraged buy-out companies like Blackstone and the Carlyle Group. Carlyle Capital, a spin-off of highly successful defense industry investor Carlyle Group (more below) took the scheme of borrowing heavily to buy mortgage-backed paper as a business model and brought it to the stock market. They issued an IPO on the Carlyle name, registration in the Isle of Guernsey, selling shares to the public through the Amsterdam Exchange! Other such highly leveraged companies went into the market selling bonds or creating further derivatives. Last summer, just before the first crack occurred, Bear Stearns, themselves, tried to palm off another load of their own toxic paper, to a subsidiary they were trying to hastily bring public.  They didn't get it launched until it was too late, thereby saving a whole bunch of suckers their money until, one assumes, the next Ponzi moment.  

Smart Guys, Smart Money

But now, this Ides of March we are just beginning to see the leading edge of the worst effects of this splurge in mindless highly leveraged bet making. What may be mind-boggling is that the so-called smartest guys, the ones who had to know what kind of toxic crap they were creating, buying, insuring, lending against and selling, so flooded the market that they got caught up eating their own dog food trying to make it still look palatable. Time-wise, it's hard not to parallel this with the exploits of Elliot (Ness) Spitzer who had boosted his career by slapping down Wall Street's greediest no-gooders.  The same week that finished with gritty, uncooperative (they had balked at joining the other big investment firms in the LTCM bail-out in the 90's) Bear Stearns finding itself in the ignominious position of being on its knees before a rival bank, JPMorgan Chase, Spitzer would have to quit as New York's Governor because money and electronic tracking traps, he himself had souped up to use on others, would, in a federal investigation, ensnare the enforcer himself, pants down.

In contrast to the "irrational exuberance" that characterized the last crash--  this time the tectonic plate has moved much further than the precincts of stock touters and patsies. This time, the folly occurred far outside the grasp of the regulators-- and it is spreading to impact ordinary home and car owners, folks on fixed incomes, municipalities, bridge and tunnel authorities and the states, themselves, who all reside way beyond the precincts of the giant global banks and investment houses.

After all, when you normally hear about margin calls, it's the banks and brokerages requiring their clients to put in more capital to back up their bets. This time around, it's the banks themselves that are hearing the margin calls.  They are being asked to "mark to market" all of this Byzantine three-letter asset-backed paper they have on their books as collateral. The only problems is, that having lost confidence in their own holdings, this time there is no market to mark to. Trading has slid to a near halt.

So guess who has opened up a window to accept the toxic waste? Why it's our very government sending in the cavalry, with bushels of ordinary people's tax dollars. That same no-good government, if you read the editorial page of the Wall Street Journal on most ordinary days, that is supposed to be standing aside and letting the private sector do it's magic.  Never mind the deficits already on the government's books, never mind the money being thrown into the endless War, the Federal Reserve now stands at the ready to suck up the waste product of greed with yet more borrowed money. And so, in this nasty tale, so sinks the dollar ever further.

Since the  fiasco of 1929, when borrowed money underlying the stock bubble brought the developed world economy to its knees,, there have been rules in place that limit a bettor's ability to borrow money to buy securities.  In recent years, the onset of leveraged and highly leveraged hedge funds has driven something of a major loophole into these rules.

There were, obviously, no such rules, only practices, in place when it came to the mortgage business at a time that the Federal Reserve was pushing interest rates down, down, down to soften the landing of the Tech Bust.

Greenspan's Legacy, the New Shadow banking System

One of the great ironies of this present and particularly alarming crash --they seem to come back to back at greater frequency--  is how avoidable it might have been had not we come to a particularly dangerous fork in the ideological setting that led up to what now is clearly going to be more than a mere "two quarters and out, garden variety recession" that the majority of economists can somehow still project. Here in Dymaxia, we often excoriate the mainstream press for their birds on a telephone wire, reflexive reporting.  Economists, seem to have invented the phenomenon. No single societal group seems to be more consistently wrong at every turn, even in their rear view mirrors. 

At their historic crest, the mood in the dominant party back in 2000 was to eliminate regulation wherever possible and to generally roll back any public protection that might have been created since the mid-Depression Roosevelt years. Unfortunately for that movement, we were in the aftermath  of the Enron debacle and it was all too crystal clear that, despite all the regulation in place, it was still possible to game the stock market big time. That wasn't the moment that Congress could be seen thinking of getting rid of the market police at the Securities and Exchange Commission, rather they begrudgingly toughened reporting standards with Sarbanes Oxley.

But the guy sitting inside the Fed, the man who'd gained palpable clout for how he'd managed the Tech Bust (by bringing interest rates down to near zero), was Alan Greenspan, an acolyte who had once literally sat at the feet of novel writer, Ayn Rand, an icon of a newly invigorated Conservative movement that was striving to restore, in Randian terms, the power of the individual over that of the collective.

Anything less than a purposely anesthetized Federal Reserve Governor, would have smelled a rat, when, in a moment of low inflation, housing prices started to take off wildly. For a boom to turn into a bubble you need a blind regulatory eye, the promise of ever rising prices to suck more and more people in and plenty of freshly printed, readily available money to lend them. The promise goes something like this: "Buy now, even if you have to borrow everything you can plus some, because this time next year you'll be able to sell, get everything back plus a profit and move on to the next killing."

Bubbles are something we will always have, as long as there's a natural dose of greed around.  But as night follows day, there will be busts, too. Fear, will sooner or later rear its head. The smart money is supposed to get in early and out of the way when the bubble begins to crash.

Ironically, central banks, like the Fed, came into being to ensure that the inevitable crashes didn't pull perfectly innocent participants going about their day to day business in the banking system into some extraneous financial world wreckage. They are there to regulate, to make rules to thwart bubbles and backstop only to protect the innocent bystanders. For such, the Fed is mainly limited to using its hold on interest rates to slow or quicken the economy, to keep things on a smooth course.

Unlike its predecessor, the Tech pyramid, the impetus for the Housing Bubble, however, can be almost entirely laid at the doorstep of the Fed, itself. The Fed quite significantly has the power to require banks to manage their lending practices.  Greenspan, it's clear, decided not to get in between the banks and their more risky business partners, including the completely unregulated hedge fund industry, even as it knew that the once hard walls separating banks and the brokerage business had been freshly pulled down.  The theory, no doubt being that savvy adults, bankers included, ought to know what they are doing and take the up as well as the down consequences for their actions.  Consequence, after all, is the cornerstone of laissez faire capitalism.

In Greenspan's zeal to unleash the unregulated hedge fund industry even as commercial banks were spreading into the investment world, he managed amnesia regarding one of the main tenants of the Austrian School that he professes adherence to, and that has to do with the printing of paper money with nothing "real" behind it.  The modern Fed is in the business of printing money with nothing behind it, no inconvenient bars of gold no silver, no nothing.  And now, in this Spring of discontent, it seems, it is also in the business of mitigating the consequences of bets gone horribly wrong.

Credit, Credit, Everywhere but not a Drop to Drink

This latest pyramid, we all know, started in the mortgage industry as homeowners were given the opportunity to trade in older more traditional mortgages for loans that had lower introductory interest rates. The kicker was that these older loans demanded a 20% down payment and over time further equity built up as the monthly payments included principal as well as interest. It's a cliché but also a truism that house's have traditionally served as a ordinary folks' largest and most important piggy bank, not, as in our present paradigm, it's ATM machine. The Fed could have cut the bubble off at its knees by taking a hard stance on the lending rules and the valuation of the derivatives that were being issued to fuel the worst excesses, the excesses that have actually brought the financial system to its knees. When questioned, Greenspan, from his pinnacle, repeatedly said he saw no intrinsic peril in the practices.

Yesterday, the government agency that measures such things, made public that for the first time since the end of World War II -- in the shadows of the Great Depression, that is-- Americans own less of their houses than do the banks and other lenders.  It came in 51% to 49%.  So much for the piggy bank and so much for the household! The conversion to a nation of debtors in just a short period was complete.

For those unhappy folks whose house now is worth less than they owe on it, there is another kind of choice: Do I hang around and struggle to pay off a mortgage, set to bump upward in many cases, or just walk away?  For a lot of folks with nothing in and facing ever scarier job prospects, this is a no brainer.  And so more houses go onto the market and prices in surrounding neighborhoods start to drop as well.  This second wave is ushering in a new chapter where companies that have borrowed on the basis of ABS-type bundles of these prime mortgages are also being called in to put up more solid collateral. Clearly, the problem has begun to spread in a number of directions. And worse for all the innocent bystanders, the Fed, in it's policy of hastily lowering interest rates, the public be damned, merely spits against the wind, yet, all the while, sewing the seeds of the next big distortion, sure to take root from interest rates that in real terms --that is, after you take inflation into account-- are already negative.

Of course, while the banks were inundating home owners with loan offers, they were also chasing every living American to open up a new line of plastic credit debt.  If you were maxed out, no worry, just consolidate --6 month teaser rate-- and come play with us, they beckoned. American families now owe an average of $28,000 in credit card debt, often with interest rate tags of over 20%, not to mention penalties if they miss a payment.

Then there's the added glow that a bubble or pyramid scheme brings to the players early in.  But this last bubble driven expansion had a weird hue to it from the start, all its own. Americans, even as their jobs were being shipped abroad, were borrowing and spending at a rate never before seen in our history, and mainly for stuff no longer made by them.  It's no exaggeration that we now  don't even question that 70% of our economy is based, not on what we make but on what we consume, nor do we second guess the massive trade imbalance that has ensued. The American consumer, it is said, is the engine that fuels the entire world economy. 

And for the world, that ought to be very bad news.  While every day consumers were borrowing, and the shadow banks were leveraging in the billions, they were being matched in spades by their own Government as it refused to tax for its own spending needs and even set the trend by running a major war --$12 billion a month-- off the books. This government borrowing together with the trade deficit has in just one Administration pushed down by half the buying power of the dollar, especially in Europe and Japan but most significantly in the Middle East, where the oil is. Consumers are now pouring money down the Exxon and Shell funnel to Arabia even before they can even get to Wal*Mart and Target for their little contribution to the Chinese dream. Never mind, the Spender in Chief encourages them to go out and spend. Got problems, he says, just save my tax cuts, and I'll send you a check in the mail.

A feeble dollar makes us all poorer but it is yet another gimmick governments use to stimulate business.  In the old model, a cheap dollar would have led to higher exports thus stimulating the domestic economy. But in a service economy where manufacturing has largely been sent abroad, there's nothing extra to sell. Goods, and particularly raw materials, from abroad get more expensive in dollar terms and before you know it you have a systemic inflationary force.  It should be noted, that the Fed is betting that a slowing economy will take care of that inflation by pushing down demand.  In other words, even as the Fed is pushing the pedal to the metal, it's betting that its mainly going to spin the wheels. That mud, it seems, is being thrown into the eyes of all those who predict this will be a two-quarters and out event.

Japan, a mega-industrial power you don't hear much about these days, has been in a state of low or no growth for over twenty years despite the fact that the Bank of Japan --their version of the Fed-- has kept interest rates a near real-term zero over most of that time. The government refuses to force the banks to clean the mountains of bad debt they accumulated in their own stock bubble way back in the 80's. Still, Japan runs an annual trade surplus with the US of over $80 billion, holds over a $trillion in reserves, and their people save at a healthy rate.  Their population continues to age and they appear culturally unable to absorb foreigners to replace their work force.  Could America's brand of borrow and bail out, create our own version of a limping giant?

Saving has totally disappeared as a concept in the US.  With houses now tapped out, university costs soaring and the education gap between high earners and the stagnant middle class ever widening, the coming generation, routinely emerges from college and graduate school with tabs in the hundreds of thousands of dollars. Working folks have to dread a medical event that can throw them into even deeper debt.

What the housing bubble did was temporarily mask the hard truth of falling manufacturing jobs and the wages and benefits that came with these often unionized jobs. Easy lending combining low (initial) payments and very loose requirements had a major impact.  Many people --depending where you live, of course-- saw the values of their homes rising by 10 or 20 percent per year as all the churning encouraged people to "trade up". The activity also brought in speculators who saw how easy it was to buy houses on margin and flip them as prices soared.

For the Administration, this was no-questions-asked territory.  It was being hailed as the result of lowering taxes on the wealthiest players in the game even as they were wracking up the biggest pay-offs of their careers. By the no-tax theory, increased activity brings increased tax revenue and the whole thing pays for itself.  So never mind, the growing domestic deficit and never mind the equally ballooning foreign trade deficit.  In the end, it would all shake itself out. And if it didn't, well that would be the problem of the next Administration, and the debt that of the next generations.

Now that this is starting to spin out of control, everyone with their own skin in the game is running the other way. No one trusts what's on the other guys books so no one is loaning despite the Fed's best efforts. Present Fed Governor Bernanke is printing money as fast as he gets interest down.  But that's like trying to stop the flow of water by putting your hands into a stream.

To attack the problem of mortgage backed securities as collateral, the Fed has announced that it will lend to banks and accept, in exchange the toxic collateral that no one else will take.  For this it has made available the sum of $400 billion dollars, which, is half the amount the Fed holds for all market intervention it makes. But that was earlier in the week, before it was forced to intervene in saving Wall Street's 5th biggest firm, Bear Stearns. This Bear Stearns rescue marks the first federal bail-out of a major bank since, yes, since, the Great Depression! To close the deal that saw JPMorgan Chase take Bear Stearns for less than the building it owns and occupies is worth, never mind the $80 billion it claimed in assets just last November, the Fed agreed to scoop up $30 billion in further toxic waste. Clearly, the skin they, the Fed, have in the game is other people's money, in this case the taxpayer's.

But that's not all that happened in this week.  In a clear echo of the Bear Stearns crack, a leveraged hedge fund started by the investment bank giant, Carlyle Group, was being called to put up more security against the $22 billion it too had borrowed to get into the mortgage security margin play game.  And so a few million here and another 100 million there and before you know it, additional billions of dollars are coming off of balance sheets of the world's great financial institutions in write-downs. In the end, the Carlyle Group decided to let technically separated Carlyle Capital sink into bankruptcy rather than pay out a billion to save it's own good name.  That decision shook all it's Wall Street lenders, including Bear Stearns where it may have been the straw that broke the camel's back.

Perfect Storm, Yet?

It's been estimated there are still more than $100 billion in write-downs to come in the area around mortgage paper alone.  Last time out, we wrote about something as obscure as the CDO's and CLO's,  called credit-default swaps, or CDS's.  This is a gargantuan insider "insurance" market that is fairly unregulated.  It is estimated to total the staggering sum of $45 trillion.  If this market should start to unravel, it is impossible to predict where the outcome might lead. And sure enough, in the noise around the collapse of Bear Stearns, there is already talk of failing CDS's. No doubt this is where the Fed has placed itself as counterparty to shield JPMorgan from god knows what else.

As we've noted, the aftershocks coming from the sub-primes has spread into what are traditionally boringly safe markets like the ones for municipal bonds. The sub-prime fiasco has also called into question the reliability of a lynch pin of the system, the credit rating agencies, which, for greed of their own, were willing to bestow their highest AAA imprimatur onto mortgage-backed securities, including some with a tranche or percentage of sub-primes in the mix. 

What's poisoning the municipal bond market, that cities, states and their agencies use to finance their projects, is the state of the so-called monoline insurers who cover the risk of municipal bonds by selling insurance on the basis of their own AAA credit ratings.  These insurers have nearly gone belly up because they too jumped into the CDO and CLO security game, providing added cover to the toxic waste products. Now the municipalities issuing bonds to cover things like stadiums, bridges, sewer systems, etc. are having a hard time convincing investors that the insurance they hold to ensure their AAA rating will actually cover them. Investors who could rely on the ratings and the insurance, are now forced to try to figure out which water company is more solvent than say, the nearby sewer authority.  As a result, mundane bond auctions have been failing for weeks on end.

There is more of the pernicious circular dynamic here since these very municipalities depend on property taxes and user fees to pay off their bonds.  As their property bases shrink as people walk away from underwater mortgages, the very income the municipalities need to pay off their debt is called into question; hence investor apprehension.

On this very shaky weekend, the thought occurred to us: what if some other unexpected jolt --our proverbial black swan-- were to hit this truly unprecedented situation, a 9/11 type event or a pandemic episode like the Avian Flu, or a run on the dollar as foreign banks moved to Euros or Yen? 

Moral Hazard

We are now at the point we predicted it would all come to: where the Fed is putting up public money to bail out the greediest layer of society, the guys whose bonuses are in the millions, who set up their shell companies in the Caribbean to get out of paying taxes on profits, who treat their salaries at the Bush capital-gains rate.  The guys who, as Warren Buffett put it, pay less in taxes than their secretaries do.

For every $billion the Fed puts up to suck up the excess waste, will players have to pay a special tax on the bonuses they took home while the party was roaring? We wager not!

And will the Fed in  it's zeal to bring interest rates down find some way to compensate regular folks for the little bit of interest they are losing on their savings?  After all, seniors present and future are encouraged to save so they will have something to live on in retirement.  Low interest rates, like pushing on a string, may stimulate some movement but it's just as likely to be as distorting as it is in Japan where housewives are said to borrow Yen at the low rates to invest in high interest places like Australia and New Zealand.  The hedge funds call this activity the carry trade and it is ready to make a comeback at a fund near you, soon.  

Posted by dymaxion at 06:29 PM

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