@ The Dymaxion Store
April 17, 2008
Hazardous Morals
Washington, DC
Moral Hazard is a term of art, it has an old fashioned kind of zing to it, like a Jane Austin novel where the cardinal points are attraction, marriage, pound sterling per year, and caddish behavior (a seducer runs off with a foolish 15 year old with no intention to marry her, or even worse, commit marriage sans income).
Lately, of course, moral hazard has become in the popular press something associated with the ongoing financial crisis. Roughly defined, it invokes the requirement that investors, fully rewarded for their wins, must also pay the whole price for their haircuts. And so, it's not bad behavior, per se, that must be reckoned to the full but behavior that results in material loss, wanton or not. In this latest crash there has been no shortage of the usual caddish behaviors: salespeople were spiffed to get customers into financially disadvantageous loan agreements, borrowers faked their personal financial data, rating agencies put their AAA imprimaturs on toxic paper, bankers created an insatiable demand for loans they could package and pass on, "counterparties" cleaned up writing default swaps they could market, regulators looked the other way, brokerages shorted the securities they themselves issued to their own customers, hedge funds borrowed heavily to get their bets into the game, bankers made extreme loans to hedge funds, bankers created off the-book entities to issue suspect paper, etc.
Meltdown and Stranded Whales
And, of course, when this rash of bad behavior went from endemic to epidemic, the usual calls for government intervention went out, first by the general public when foreclosure signs began to sprout in their neighborhoods like mushrooms in a rainy Fall and then in the weightier pages of the WSJ and FT when it became clear that the great investment houses, themselves, had been left swallowing their own toxic waste and melting into the ground like a serial Three Mile Manhattan, London and Basil. As fast as the Fed and the ECB pumped "liquidity" into the markets, the faster the banking system seemed to fuse to a halt. Something more radical than winners and losers was occurring, hence the concerted move to a bail time-out for the whales left flapping on the beaches.
For the cynics here in Dymaxia, it came as no surprise that the bailouts would extend well beyond the former limits of the commercial banks all the way to the free-market precincts of the hedge fund industry. After all, by definition hedge funds are highly leveraged entities that do their borrowing from their willing commercial and investment banker brethren. We also remembered Ben Bernanke's famous "helicopter" speech in which he vowed to keep the government printing presses going day and night to supply whatever money might be needed to keep the system off (or on, we couldn't recall) its knees.
To ourselves, laying down the editorial pages of the Wall Street Journal, we mused, moral hazard is about as quaint a notion today as the characters in Austin's Sense and Sensibility might have appeared to Choderlos de Laclos, the author of Les Liaisons Dangereuses, had he lived long enough to contemplate them. In the end, it was the chronicler of another gilded age that seemed more appropriate, and so we deferred to the much maligned Marquis de Sade for our contemporary standards for hazardous morals.
As we noted in our last posting,
Pushing on a String of Discontent: Bernanke's Tale: Bernanke's Tale, the Wall Street executives who led their companies so deeply into this quagmire, would surely not admit, even under oath, that the good performance their companies produced as the pyramid scheme unfolded, and for which they were so richly rewarded by cash and stock option bonuses, had little or nothing to do with the hard landings their companies were experiencing today. "Who could have predicted," their chorus lamented, "that the unprecedented growth in home equity and home ownership, would have resulted in a bursting bubble?" And like all farces that recount the foibles of the Gods, economists, the regulators and the mainstream press, echoed in polyphonic tone from across the stage, "who would have predicted"?
And so, in keeping with the moment's theme of decadent farce and moral hazard, we asked rhetorically, will those entities that are now rushing in to save the remnants of Bear Stearns (it was too late for these guys who, it appears, were so swimming in toxic waste that a special $29 billion fund had to be set aside by the Fed to soak it up) and most recently Lehman Brothers (they've already availed of $4 billion in back-up spare change) be asked to take back some of the bonuses that were paid out to top executives during the recent up years?
The answer, of course, is that it will take another round of heat, at least, before anyone begins looking for a couple of high level guys for some communal bloodletting. After all, James Cayne, the Chairman and CEO at Bear Stearns, we hear from those same journalists who continue to insist on calling that company's forced by-out, a non-bailout, has paid dearly for the loss of equity he suffered. His shares, they remind us, went for $10 a piece when just a couple of years ago they were trading at $171. We are, by this light, supposed to suffer for the good chap who like a Long Island Nero, played bridge while his firm and his bonus shares sank into the clutches of the goodly fiends at JPMorgan Chase.
Quaint, we say, because today's gilded age has funneled so much wealth into the hands of this super class that counts its yearly earnings not in the hundreds of millions but in the thousands of millions of dollars even while the tax rates paid by this über group are less than those paid by the lowest wage earners. Last year, a tepid attempt by Congress to reckon hedge fund manager earnings as taxable earnings was quickly shunted to that special place on Capitol Hill where all high minded efforts go to be stored, like Walt Disney's body, for a better day.
Leveraged Fall Out
Speaking of which, the distortions created by economic policies that hide the cost of war, rely on declared and hidden deficit spending, encourage plastic-based consumerism, personal credit extension, negative real-term interest rates to discourage saving, and money printing dollar devaluation are now emerging like the dead from the earth on Judgment Day: basic commodities, like food and energy costs ripple upward even as economic activity slows, the banks, unsure of the value of their own securities, refrain from lending and wages continue to fall for the vast middle even by normal definitions-- measured against wages in the Euro and Yen zone, the loss in buying power for the average American over the decade has accelerated in a way that is astounding.
The housing bubble, the ultimate, live today, pay tomorrow spree, where anybody could borrow as much as he wanted, was the antidote to the sinking of American economic hegemony. And yet there is also a Main Street equivalent to the moral hazard story that has appeared, like a throwback to some cloth coat Republican era, both in George Bush's and John McCain's rhetoric as they have been forced to grasp the systemic and political implications of a housing bubble meltdown: never mind the dastardly builders, loan brokers and debt packagers, what about all those obnoxious speculators you used to run into at every wedding, first communion and bar mitzvah party? All of them had just successfully flipped a whole bunch of condos somewhere or other, turned their log cabin into a country manor house and had all become safely installed in their suburban equivalent of Monticello. Are these the guys who need to be bailed out of all their flimsy loan deals?
As for those Members of Congress who are supposed to be working to get aid to all the poor folks who just happened to get sucked into the housing frenzy at the wrong moment or through devious paper sleight of hand (remember those spiffs that pulled brokers toward selling loans with trap doors built in) , we wish them the best or luck. They will need every ounce of backbone they can stiffen, or, not only will the lion's share go to the same scoundrels who partied on the way up (NYTimes on the Senate version,
Big Tax Breaks for Businesses in Housing Bill) but also to the shareholders of the two big once quasi governmental agencies that were designed during the New Deal to save housing during that desperate period, Fanny Mae and Freddy Mac. The proposal on the table would build in government backing to expand Fanny and Freddy's capacity to lend to soak up bad mortgages designed to spin out of control with a new crop of fixed-rate models to homeowners even if their present houses are already underwater.
Beyond the personal debacles, a falling housing market that might lose up to 40% of present value is predicted to cause the kind of Main Street financial chaos that would spread beyond containment. Of course, the new plan would require the Federal Government to provide guarantees for all these new underwater loans in case homeowners just plain decide to walk away from their homes in search of greener pastures. It needs to be noted that here, once again, the backstop is going to be the already battered dollar, and the recipient agencies, though hybrids of a sort (Fannie, for instance, uses its quasi status to avoid paying local property taxes for its headquarters in DC), these are private stock issuing entities just emerging from bookkeeping scandals that fortified private industry level salaries and bonuses for their executives.
You already know that the US finances a very expensive war by printing dollars off the books (which no doubt explains why billions of them have just disappeared into the Mesopotamian underground) runs a built in deficit that grows from year to year and buys ever more from abroad. The Federal Reserve is providing hundreds of billions to backstop a financial system that has taken shock one, the blowback from the sub-prime crisis but may soon face the prospect of seeing the loans and counterparty paper issued to "insure" the equally speculative business of highly leveraged buyouts come a cropper as well. This Recession is like the new year, hardly a baby still. Prolonged recessions can be trouble for a number of corporations under normal circumstances but for leveraged buyouts paying out enormous debt loads, a few bad quarters can be as toxic as the sub-primes were for leveraged financial giants like Bear and Lehman Bros.
We recall that up to a short while a ago, LBO's, or leveraged buy-outs, were all the rage on Wall Street. Last week, one of them, Linen and Things, with 17,000 employees around the country, announced they were shutting their doors. With gas prices expected to hit $4 a gallon this summer ( it's already there in some places, while the Diesel fuel that truckers rely on has already passed that line across the country), building activity down, and the price for food hitting the roof, it's hard to believe that Linen and Things will be the only stretched out retailer to bite the dust. As the Chinese currency, the RMB is inevitably pushed up to counter the worldwide inflation in raw materials, the price of retail goods in the US will have to move with it, despite what the round smiley face signs at the end of the aisle tell us.
Those who argue that this Recession still has a long way down to go, certainly have more than their share of arguments and data to back it up. Watch out!
March 19, 2008
Pushing on a String of Discontent: Bernanke's Tale
Washington, DC
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.
January 23, 2008
Move Over Subprime , It's Primetime for Credit Default Swaps
Washington, DC
As if, after centuries of debacles, we needed proof that greed and fear will trump rationality in the affairs of men big and small; once again, we are peering down that precipice of folly called "the market knows best". This Gilded Age that even the Enron debacle couldn't derail has now come to crash. And oh, by the way, the rest of us will be left to swab the blood and piece together the remains.
Last month we warned that the second shoe is about to drop as subprimes move off the front pages to make room for something more obscure but potentially even more toxic, called credit default swaps or CDS's. And once again, as with the problem of the subprime mortgage disaster extending far beyond the problem of millions of people unable to make their home payments and the falling home prices of their neighbors but rather to the mountain of three-letter (CDO, CLO, SIV, etc..) financial rigmarole that the banking system and the shadow financial system generated on top of the mortgages, the failure of billions of dollars in CDS's and their derivatives, will rain down on all of us.
Remember, banks in China, Singapore, even a few small towns in Norway and some of the biggest world-straddling financial institutions are all still trying to figure out how much they lost buying the toxic waste their bond development arms so profitably generated in the pyramid scheme that led up to the latter stages of the subprime crash. Financial institution balance sheet losses, alone, are conservatively estimated to be in the range of $250 billion when all the off-book transactions are brought into the open as write downs..
Counterparty, What's a Counterparty?
Unfortunately, as they say on prime time, there's more to come, folks: the credit default swaps --insurance policies with little money behind them-- are whole new episodes still to be played out. And when it's all done the major economies of the world will have thrown further billions in taxpayer money at the various debacles. Only the scoundrels who conceived of the pyramid and spread the bets around, will be left with their fortunes intact; for, if we've learned anything at all, we know that the bailouts will be seen as necessary to keep the system from crashing entirely and the guys who walked away and the guys who were supposed to be regulating them will be off laughing, no doubt conspiring on the next bubble.
It might be sobering to note that there are estimated to be $45 trillion in CDS's in circulation as we write this, that, in case you're not counting, amounts to approximately 3 years worth of the entire US economy! CDS's are designed to act as insurance against the default of specific junk bonds, bundles of bonds or, their derivatives, and in a further twist, of the same companies that issued the insurance swaps in the first place. They have existed in a market outside of, but impacting the bond insurance traditionally issued by the monoline companies to guarantee corporate and municipal bonds and the complex rating system that determines the interest rates that companies and municipalities end up paying as they rotate their borrowing sometimes on a weekly or monthly basis.
But as CDS's took off even the sleepy monoline insurance business got a hit of cocaine in the last few years and got into the more lucrative business of using their AAA credit ratings to issue insurance on the CDO's that Wall Street was using to finance the subprime mortgage bubble. As a result nearly all of the major bond insurers (Ambac and MBIA, are the leaders) are now facing bankruptcy, unable to take on the financing needed to cover their obligations without so diluting their capital that takeover vultures will rush in right behind the capital injections. This is still to be played out as bailouts get structured (here's a Marketwatch article).
In the meantime, with the money spigot left wide open by the Fed, the vast majority of squirrelly bonds issued by Wall Street was "junk" rated and thus out of the realm of the regular insurers --who, by the way, are also required to keep a certain amount of reserves on their books to back up the insurance or lose their vaunted credit ratings-- and so a whole new range of players stepped in to fill the void with these CDS's. The issuers, whether hedge funds or off-the-book brokerage house and bank financed companies, created mountains of new paper insuring, as we noted, not only the derivative products but the derivatives that were derived from bundling derivatives (you wonder who would have bought into this game?). These new insurers, or counterparties, as they're called on Wall Street, were totally unregulated, existed outside the realm of the already overly loose playing ratings agencies, and thus had no real obligation, other than their own guarantees, to keep any reserves on hand. And, of course, as quickly as the hedge funds were able to amass piles of cash, they could disappear as investors smelling the coming debacle, pulled their money out.
Like the subprime mortgages that were issued by people who were paid to write them but who carried no risk should they go bad, the CDS writers and the brokerage houses that moved their paper guarantees had little to worry about and plenty to gain in the short term. The clearest description of what a CDS is came in some of our reading last week. The author --who will have to go without credit as we forgot to pencil in a note-- called them something akin to side-bets that viewers of a sporting event make between themselves along the side-lines. CDS's, it turns out, were bought and sold by participants who were not holding the underlying securities that were insured. In that way they opened the door to speculators who might be trying to short the derivative, junk bond or CDO, etc. markets.
In free market theory all this activity would be beneficial to the overall market as it spreads the risk or at worst, would be detrimental strictly to the players on the wrong side of a bet.
According to this line of thinking, you've got supposedly shrewd and savvy people managing other supposedly smart, shrewd and savvy people's money making their own bets on how things will play out. This "hedging" or "speculative" activity, depending on the bettors perspective, is theoretically supposed to allow more granulated approaches to larger market forces thus smoothing out discrepancies that might otherwise disproportionately tilt them. Unfortunately, as we are once again about to see so tragically, it doesn't work that way when the guys who start the pyramid game get to walk away Scot free leaving people who never ever heard of a hedge fund, much less, a CDS to pay the piper! That's where we are today as markets around the world tumble and the Central Bankers and politicians scurry to print more paper, this time in the form of legal tender, thus diluting everybody.
It's Pay Up Time
The big problem with the CDS's is that losses involving this paper may total another $250 billion or perhaps much more, according to the calculations of people like Ted Seides (see our last piece, The Next Big, Big Crack) Junk bonds by their very definition, are bonds issued by entities with weak balance sheets. They pay higher interest because there is a higher probably some of them fail. Historically, these defaults run in a range, depending on the relative financial health of the issuer, from about 2.8% to 4.7 % in normal times. With the pool of junk bonds expanding over the last few years in a borrowers market when investors were willing to buy just about anything sporting even a small risk payoff (in fact the premium between Treasury's and junk had never been narrower), there's lots of room for future failure. It's also obvious that in a recession the percentage of failing companies increases significantly and therefore the number of failing bonds increases. It may, with a deeper than normal recession looming, then be much more that an average failure rate for low rated junk of 4.7% over the next couple of years, if so the losses would be nearly $1/2 trillion just in CDS's. And once again, no one knows who the counterparties are and where they could possibly come up with that kind of money (we can guess with great certainty, they can't) and, more importantly, who is holding all these CDS's that are likely to sink to pennies on the dollar. Imagine the big banks going through another round of hat-in-hand begging for cash injections around the globe. Any takers for side bets on whether the governments will step in?
Now comes the US recession and an ongoing crisis in the world financial system still trying to swallow the subprime debacle's losses and we can now foresee the failure of numerous junk bond issuers. As those bonds fail, investors will turn to the CDS issuers to cover the defaults. And, of course, the issuers of those guarantees will be nowhere to be found, their gains tucked handily out of reach in offshore havens that require no reporting and no taxes. No wonder the Fed and the Treasury Secretary have gone into panic mode!
Meanwhile, the so-called US or world recession will deepen as the authorities begin to dig deeper and deeper into their rescue strategies. Nobody, except maybe the GOP candidates, will be lauding the free market system as it becomes time to start wiping the blood off the floor. Stock holders and investors will be the first to be hit but certainly won't be the worst victims of the folly that let $45 trillion in insurance be issued without any reserve requirements. Interest rates will be forced down affecting older Americans whose incomes are tied to them, families with large credit card debt will default, governments will struggle with lower tax revenues and begin cutting programs designed to protect their taxpayers, good jobs will be lost at an even faster pace then during the "good times' of the last 4 years. As Wall Street insider and serial bull, Mort Zuckerman, so out of character, put it on the weekly John McLaughlin Show, we're looking down the barrel of the worst recession since 1929.
The already wounded large banks will struggle once again to cover the next round of losses brought around by the CDS debacle and new and larger pieces of America will go on fire sale to those private and "sovereign" entities sitting with their coffers stuffed with dollars that have been passing so quickly through Wall*Mart, Exxon, etc. conveyor belts on their way East. The CDS debacle will be this chapter's Black Swan.
That's why nobody thinks the $150 billion stimulus plan proposed by the President with Congress on the bandwagon is going to do more than a peashooter aimed at a tsunami. Just as sharply lower interest rates in the US will only accelerate the race out of the dollar thus fueling a new round of strange distortions down the road.
Bush, it looks like, will finally get to truly exceed his father. The 2nd Bush Recession, potentially the worst since 1929, on top of the series of debacles around the world of this regime, and a bleeding dollar will put the nail in the coffin of the Reagan Revolution. The party of domestic deficit spending, unfettered trade policies in the face of enormous dollar trade deficits, moving social security money to Wall Street, off the books war spending, and the dogmatic unfettering of the activities of the world's pyramid scheme guys, will likely come to an end. Already you can see it coming apart as the so-called social conservatives get fleeced at the gas pump on their way to jobs or homes that might not be there next month, the defense hawks contemplate unending $trillion, force-draining occupations of Iraq and Afghanistan and the fiscal conservatives see their savings eaten away by a diluted dollar.
Imagine a country with high unemployment, millions of personal bankruptcies and foreclosures, bailed out banks and brokerages and a social safety net in tatters; now think about the lip licking, fire-sale vultures waiting in the wings to swoop in, who have gotten away with the loot thanks in part to egregious tax loopholes that not even a Democratic congress had the guts to close. If that doesn't make you mad, nothing will.
December 03, 2007
The Next Big, Big Crack
Washington, DC
We have, it seems, evolved a political/media system that nearly guarantees no remedies until the damage has been done, the scoundrels have safely buried the loot, and there is a full blown crisis on hand. It's not just the politicians out there running reverses and repeating tired saws that negate even their own private thoughts; it is also the media pundit chorus, people purportedly paid to do some quality thinking who, it seems. all too often forget how little they really know.
We got back to the States two weeks ago, in time to hear the weekend bloviators indicate almost unanimously that Hillary Clinton had wrapped up the Democratic presidential nomination. Only on the following Monday when an ABC Washington Post poll came out of Iowa were they stunned into realizing that all of their hot air and spin had to be revised. Somehow, Iowans --the folks who actually will be making up their minds in 5 weeks-- had, like their credit cards, maxed out on Hillary's message of a return to the good old days.
What Don't They Miss?
Pundits, of course, travel on other peoples' credit cards and sometimes even get to dine and rub shoulders with the Great Gatsby crowd that have had a great run these last few years. For them, the sound and smell of little people's mortgages going up in smoke is as far away as one of Jupiter's liquid moons. Nothing it seems can divert their eyes from the talking points coming across the transom, not even the unseemly multibillion dollar panhandling in Arabia of giant financial institutions --Bear Stearns, Merrill Lynch, Citibank, Bank of America, HSBC, to name a few- as stoppers to the hundreds of billions of dollars in write-downs they are taking for holding derivatives (many of their own making-- that were somehow supposed to have allowed them to sprinkle fairy dust on the toxic waste they'd bundled into tidy CDO's, CLO's, MBS's, etc.) (For a lot more detail on this alphabet soup mess, please have a look at our July 27 piece The Big Crack )
That trillions of dollars have flowed out of the US and into the coffers of sheikdoms small and large, friend and foe, as well as to our East Asian allies and rivals is something best left to the money men to figure out, it seems. Even when great banks teeter on the brink, and CEO's are forced packing, we hear nary a peep out of the political and media class.
Does anyone among the poobahs and sages wonder how it is that nearly all these so-called sophisticated money men, and their peanut counters in the back room bought so heavily into their own waste product? Or in the more convoluted case of Goldman Sachs, shorted the lousy paper they were selling to their best customers (even while the present Secretary of the Treasury was still leading the firm)?
Hardy, though Paul Krugman, the Princeton economist and New York Times columnist, who does do his own thinking, had a simple way of nailing it; greed in the corner office in a political environment that has put the foxes in full control of the henhouse. Krugman has made the Enron-revisited point that none of the CEO's who've lost their jobs as the multibillion dollar losses of the subprime crisis have hit the fan, has had to give back his golden parachute going forward or the obscene, bonus-based, pay packages they collected during the years they were ginning up the phony mortgage market and creating the mountains of bad paper --they secretly called "toxic waste"-- their institutions and stockholders are now forced to swallow and that is shaking world financial markets.
The Farce Begins
The Friday November, 30th Wall Street Journal reports that the Bush Administration --the same guys who advocated that Social Security should be replaced by private investment accounts in the markets-- is in the process of negotiating with the banks with an end result that is sure to mean --even if its hidden in the deal-- that the taxpayers will soon be subsidizing the banks as well.
Here's a good pundit question to be asked: Will the Democratic Congress ratify a deal designed to help the banks and the holders of some of the many balloon mortgages that are scheduled to blow up as rate increases kick-in, without asking that at least some of those bank and hedge fund executives who have pulled in billions of dollars in bonuses for the last few years to give back any of their bonuses and commissions, in return for a rescue of their scams?
We, here in Dymaxia, are willing to bet that the question will hardly arise before it gets buried like a lead pipe in a toxic waste dump. After all, this sitting Congress already has a record on hedge fund bonus money; i.e., they continue to allow it to be called "capital gains" by the hedge fund moguls, so it can be taxed at 15%, half the rate the folks who sweep their offices pay on their earnings!
But bank sub-prime paper mega-write-downs (see the E*Trade deal where $3 billion in CDOs was turned overnight into $800,000, for instance) also strike at lots of folks who have pensions invested in the banking industry not to mention bank stocks in their mutual fund portfolios. In the case of Citigroup (CIT), alone, shareholders have, since the beginning of the year, lost approximately two thirds of the value of their holdings, or more than $80 billion dollars. In E*Trade's (ETFC) case, shareholders have lost more than three-quarters of their holdings.
CIT is, or was, of course the world's largest financial institution. In desperation, to stay above water it negotiated a deal in which it promised to pay its rescuer, the Abu Dhabi government, 11% interest on the $7.5 billion cash injection it received this week. In today's world where very big money accrues even to individuals if they're in the right place, $7.5 billion probably doesn't sound like a lot to a pundit's ear. It was, it turns out, enough to buy nearly 5 percent of our biggest bank. Importantly, for the gulf state oil sheikdoms, it represents probably only a few-day flow of petrodollars; here, it seems, the pundits and the petro-billionaires can agree!
Trillions of dollars, of course, is real money even in Washington where they print the stuff. No one knows where it all goes except when big purchases become visible like the Chinese attempt to buy a large oil company with significant reserves or when the management of our major ports goes on the block. What the Citigroup deal points out is that these outside government and quasi-government players in the Gulf States (including Saudi Arabia, of course), China, and Russia are likely to continue to gain clout as the major tectonic shifts of the current crisis continue to shake the banking system.
Now, imagine for a minute that subprime mortgage based money creation was not an anomaly and that there are parallel but even larger fault lines still to come into play! Impossible, you say?
Here's the way it works when the Fed and the regulators are betting on the private sector to regulate itself: banks and their proxies earn immediate money by lending time bombs that don't go off for several years; bigger banks and hedge funds earn money on these foolish loans by packaging them and turning them into respectable derivatives they sell without, in many cases having to pay a middle man or market fee directly to their customers; rating companies profit by this new business stream and give out their imprimatur of a high credit ratings to this paper now three steps removed from the original loan; other banks and insurers serve as counterparty guarantors, buying and selling the obligations as investment grade to their customers or hold as reserves, thereby "spreading the risk" eventually around the globe.
Are Junk Bonds the Next Junk Bombs?
When it became clear last summer that the entire world banking system had been gaming itself as the US home mortgage bubble reached gargantuan proportions, politicians and their sock puppets looked the other way, spouting the usual nonsense about the core economy being sound. Neither party could see perils without an equal mix of good news in dealing with the crisis.
Now that the problem has spread beyond the growing rash of foreclosures (these only affect ordinary people and are thus ..........) and to the foundations of the major banks thereby threatening pension funds and even bank deposit holders, the problem still gets less notice by the commentators than the daily swings of the Dow Jones Index. It's almost as if on the day the twin trade towers fell, the stock market stayed open and went on to gain a couple of hundred points so the headlines read: "Despite Early Fall, Markets up on Gains in Scrap Metal, National Security and Office Building Prospects". The Dow Jones Index now seems to be the only gauge the media use to measure events on the ground.
Official Blindness
Pundits are an important component of the information flow, since they shape public opinion; so how they get spun matters much. Politicians, we know, who get out in front of public opinion face ridicule and sudden death, which is probably why there are mere nuances of differences in the platforms of all the Democratic candidates, minus say, Kucinich and for all the Republican's, Ron Paul. The pundits, as we noted, tend to read each other, hoping, one supposes, that one among them knows something. The rest of the time they rely upon being fed thought aids by the lobbyists and other operatives, the guys who earn the big bucks in Washington.
Unlimited Dollars All Around
Public money used to have meaning in Washington until Ronald Reagan intuited that debt, in our new economy, had become as American, say, as a wallet full of credit cards. Take the 5th year of the Iraq Occupation. The United States continues to spend off budget nearly 10 billion dollars a month on Iraq, or, in annual terms, nearly one percent of our entire annual gross national product. To make this palatable, the Administration has raised no taxes but preferred to merely further run up our national debt, something it has been doing across the board without much pushback, anyway.
As we've often pointed out here in BlowBack, since Bretton Woods, the US has had a built-in cushion that allowed it to spread its debt practically cost free around the world. The privilege, a massive type of seigneurage, was made the base of a system in which dollars printed here and spent to buy foreign goods and services often don't show up for payment but instead get held by other countries as a Reserve Currency It's a great benefit that any country would be envious of; nonetheless, there can be too much of a good thing; the system has been allowed to perpetuate right into this massively financial global era, allowing trillions of dollars to build up outside the country in the last few years as China and petrodollar debts mounted geometrically.
Now that there are these trillions of dollars out there, it doesn't take a perfect storm scenario to imagine what kind of an avalanche a real crack here --say, a major bank or brokerage going under, might set off! China and oil producing nations, should more bad paper start to unwind, might be tempted to cut their losses and try to recycle those dollars into "real" investments, like shares, say, in hat in hand banks or teetering corporations or in the holders of natural resources..
It now looks like one indirect result of the Iraq adventure will be the future dismantling of Bretton Woods. Since Bush took office the dollar has lost more than half of its value if gold, oil or other raw materials, including food grains) are used as a counter value.
Our pundit class, of course, never mentions the actual financial cost of the occupation, even as many of them advocate stretching it out as far as the eye can see, once again imagining that the US can go on printing dollars indefinitely just like in the good old days.
But this level of obliviousness, unreality and folly is, of course, hardly limited to the falling dollar, the collapsing mortgage market, the strains showing in the banking system from Citibank to E-Trade or even the looming recession.
CDS, the Next Dominos, Junk Bonds and Counterparts
To get to the Perfect Storm scenario, another shoe might have to drop and it looks like junk bonds may very well be the next subprimes:
This week, we read a compelling piece on where the next big crack might occur, thanks to the research of Ted Seides, as republished by John Mauldin in his Nov 26th "Outside the Box" weekly e-letter. Seides entitled his essay The Next Dominos, Junk Bond and Counterpary Risk. In his article, Seides makes the point that the total amount of derivatives issued by the financial institution bundling mortgage debt, pales in comparison with the amount of deriivatives (CDS) that are in circulation, built not on mortgages but around corporate Junk Bonds, which, he points out, are by definition are high risk vehicles.
According to Seides, there are $45 trillion (yes, trillion with a T or more than three years of US GNP) of these derivatives sitting on the balance sheets of financial institutions around the world. He also makes the searing point that there are no reserves (or counterparts, as he calls them) to back these CDS's up. The issuing banks and hedge funds are the guarantors and they have not been required to set any countervailing funds aside to support the paper they've issued.
Here are a selection of attention-grabbing quotes from Seides piece that, unfortunately does not appear to be available on line, yet:
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Does this all sound familiar? It should if you've followed the sub-prime debacle!
The Black Swan in the Room
We take our lead from Nassim Nicholas Taleb, mathematician, empiricist and trader, who can be fairly ranked as one our worthiest contemporary anti-pundits. NNT, as he likes to refer to himself is, most recently, the author of The Black Swan, The Impact of the Highly Improbable. In this book and others, Taleb argues that contrary to the thinking of the punditry, or all those who would predict the future based on the norms of the past, randomness plays a much greater role in the outcome of history than is even vaguely appreciated by those whose world is routinely described by the bell curve of probabilities. For Taleb, it's not just that backward looking statistics lie but when it comes to seeing what might lie ahead, they are as useless as an ice cube in hell.
The Black Swan is, of course, his metaphor, for something that is totally unexpected (by all, but those close to it, and even they often don't realize the true extent --remember Watson, the founder of IBM predicted there might be a market for four of his machines!) until it is actually developed and injected into the system. In the world of mediocrity, the land of the pundits and politicians, there are no black swans but, as NNT points out, we do not live in "Mediocristan" but instead in "Extremistan". Taleb, of course, can easily point to a string of even recent developments that have appeared "unexpectedly" that have radically and irreversibly changed the way the world functions, from central processing computer chips to the Internet, to mobile phones, (to, yes, the subprime loan debacle that was on no MSM analyst's radar up to just a few months ago), etc.
Mediocristan or Extremistan?
As we've said often in these pages, it sure doesn't look like Mediocristan out there as we watch the markets jerk up and down like vaporetto commuters in Venice, even as we watch the bailouts big and small at banks all over the globe and as we mull over all those unregulated hedge funds --the new counterparties-- going after "absolute profits" for themselves and their clients.
In Mediocristan it all shakes out, reason trumps greed and the beat goes on,,lati lati do!