October 24, 2008

Financial Freefall


(for an easier to read version see:
Densidad Regional /
Throwing Spaghetti to the Wall

Monday October 13th the G7 finance ministers returned to their governments from the International Monetary Fund and Finance Committee (IMFC) meeting and photo-op at the US Treasury. The World's dailies all led with the same story of substantial gains on World stock markets, helping foment the hope that the "coordinated bailout" had worked. Could this eliminate the horrifying specter of 1930's-style economic depression by preventing financial collapse? Had confidence returned to refresh what John Maynard Keynes' called The Animal Spirits of capitalism[1]?

Maybe not!

Monday October 13th the G7 finance ministers returned to their governments from the International Monetary Fund and Finance Committee (IMFC) meeting and photo-op at the US Treasury. The World’s dailies all led with the same story of substantial gains on World stock markets, helping foment the hope that the “coordinated bailout” had worked. Could this eliminate the horrifying specter of 1930’s-style economic depression by preventing financial collapse? Had confidence returned to refresh what John Maynard Keynes’ called The Animal Spirits[1] of capitalism? Maybe not!

That same Monday the US government announced the largest ever investment of US public money (over $700 Billions) in the private financial industry and the S&P 500 had its largest one-day rise since the 1930’s depression. Tuesday did not go so well. Wednesday, the US treasury began pumping $250 billion into the US banking sector, however the S&P 500 had its worst one-day fall[2] since Black Monday in 1987.

The rest of the week saw stock markets thrash across the world, with the highest volatility measures on record. The Chicago Board of Options Exchange keeps an index of the near-term volatility of the S&P 500 called the VIX[3]. The VIX has hovered around 15% for the past few decades; it touched an all time high of 80% that week, by the week after it had almost touched 90%. The most active trading was in the markets that trade the markets, (the derivatives markets), managed by hedge funds and what is left of the investment-banking sector. Hedged positions unraveled resulting in massive sell-offs, some hedge funds have gone belly-up, others are essentially insolvent, and a few stopped trading, citing the unpredictability of the market[sic.] while others still were making fortunes. As the stock markets convulsed violently, the credit markets eyed up the massive new flows of tax-payer cash with cautious optimism and an eye to their shareholder’s bottom line.

A Busy Week
On October 11, the leaders of the G7, some of the World’s largest financial economies, met to hash out a coordinated attempt to stem financial collapse. For much the same reasons, the next day the G7 (and the non-G7) Europeans were again meeting in Brussels.

Alistair Darling, Gordon Brown’s new Chancellor of the British Exchequer participated in both groups. London is the World’s largest financial center and business has been booming. UK financial services rose 50% from 2003 to 2007. The UK is also the source of much hedge fund innovation. Among the European nations, it is most at risk from collapse but its financial services industry has the most to lose from regulation. Prime Minister Gordon Brown announced a £400 billion pound rescue plan, aid for its financial services industry. He also evangelized the British rescue model to his global counterparts.

Gordon Brown is himself no stranger to the banking industry. In 2004, he is rumored to have been offered a position of head of the IMF[4]. Opting instead for the highest role in British politics, Brown and his Chancellor of the Exchequer, another Scotsman, Alistair Darling, find themselves again negotiating with bankers. The week of the bailout announcement the markets were arguing furiously as to how much of the pain they were being asked to bear. Institutional investors in the banks in crisis wrangled for a slice of the bailout pie. The idea of Darling’s blanket ban on financial share dividends was to prevent the public cash being paid out into private hands and to force the Banks to recapitalize themselves; the markets didn’t like it so it was shelved. The Financial Times reported that Mr. Darling was furious with Eric Daniels[5], CEO of British Bank Lloyds TSB, for “trying to unpick the deal” accusing the bank management and ownership of trying to “get off the hook”.

Similar hasty negotiations have been taking place across the planet as politicians are informed that they have little choice but to agree to bail out the global banking sector. World leaders returned to their national constituencies to explain in somber tones that throwing trillions of dollars of tax money into the world’s frozen financial credit system would thaw it sufficiently to prevent the dread disorderly unwinding. Few of these World leaders have the faintest idea how these incredibly costly plans will work out, if indeed they do. This is the genius of derivatives, even the central bankers find them opaque.

Now is not the time for detail, it is time for measured but firm words in the face of Global Crisis. National leaders in the economically neoclassical European Union acidulously tried to avoid using the term “nationalize” when speaking of injection of public funds into a global banking system. That said, in Europe alone, the equivalent of nearly €2 Trillion in national tax-payer funds are being fed to starved national credit markets in a hope that this will nourish them back to health. Even the largely defunct IMF is getting in on the act, trying to rescue the Icelandic economy with massive loans.

In the highly leveraged World of Wall Street derivatives, the situation is looking grim. In Wall Street, a source of much of the crisis, the FED is desperately trying to deal with a toxic mix of bursting bubbles. Even in the US, the government decided to make an abrupt policy about turn. The US Treasury secretary, Hank Paulson[6] originally planned to buy up the toxic securities from the banks that hold them as mark-to-market “assets” thereby curing the issues by attacking the problem at its source. Then Paulson changed his mind and went for the lubrication option of injecting tax money as liquidity into the banking system directly. Some distinguished economists[7] consider that by lubricating the market Paulson will thereby float the credit derivatives bubble and the engorged banks that hold them, leaving the bubbles to burst later.

The original idea was to buy the toxic securities with tax money but it may be too late as they have so little value the banks would still remain undercapitalized if the government paid the correct price for those toxic derivatives to get them off the market. It can be argued that if this is true then the system is bound to fail because the leveraging cannot be de-leveraged quickly enough.

The question remains; why, if this is true, even go ahead with this bailout?

Nationalizing Foreign Food
Injecting public funds into an ailing global financial system is like throwing spaghetti to the wall. If it sticks, the chefs congratulate each other over the successful recipe. If this coordinated bailout sticks then, presumably, the financial system will hold together long enough to unwind in an orderly fashion. However, unwind it must. Behind the scenes, the regulation agencies and the FBI will be forced to spank the wrists of a few derivatives traders and investment bankers, while banking shareholders get rescued by government food stamps.

In the United States reaching an agreement on the emergency aid was a difficult matter. The menus offered to the US House of Representatives differed. They had the same price tag —about $700 Billion— ingredients, however, may vary. Surprisingly the first menu offered was rejected on September 29th, but the aptly named TARP (Troubled Asset Relief Program[8]) passed in the house on October 3rd and was hastily signed into law. The TARP was similar to the previous plan rejected earlier that week. Stirring in a few billion dollars of pork[9] before the election made the second offer more digestible to state Representatives.

What might happen if the spaghetti fails to stick? Might it be necessary that a few more thousands of billions of dollars in taxpayer cash could be required to keep the corporate ATM machines functioning? Would further nationalization work? If so, for whom? The falls in the stock markets, especially in financial stocks, are simply reacting to the fact that financial investment and refinancing groups (some very private in nature) have overreached themselves. Stock market drops are a symptom of ill-health on a much larger scale, trading in derivatives markets is much larger than stock market trading, or at least it used to be. No one really knows if injection of public funds will solve anything. From a stocks perspective Monday the 13 could just have been a dead cat bounce on a grand scale.

What Went Wrong?
Is the global financial system terminally wounded? How will this affect the so-called “real economy” if it dies? What shall replace it? Could it be also that rumors its death been gravely exaggerated? Dean Baker of the CEPR[10] has criticized US President Bush for the anxiety he caused in his address to the nation by evoking the 1930’s depression. Mr. Bush has been shown to be less than truthful in the past when unpopular large-ticket expenditure is put to the public. This was the case with the war in Iraq for example. In 2002, President Bush fired Lawrence Lindsey, his assistant for Economic Policy, for suggesting that that war might cost $100 to $200 billion; Joseph Stiglitz has since written a book[11] that puts the then cost at $2 to $3 Trillions. How much could a bailout cost?

What is clear is that much of the affected $50 trillion of more than $200 trillion US derivatives markets is poisoned and bloated with bad debt. To cure bloating a good doctor prescribes a diet. What is not clear is whether the diet will be terminal nor whether the illness can be isolated from contagion. Whatever happens it seems likely that 2008 Christmas bonuses at Goldman Sachs may dip below last year’s average of $600,000[12].

What is the link with house prices?
The financial press names “toxic securities” or simply “toxic assets” as responsible for this financial pandemic? The less sophisticated press blames the crisis on sub-prime mortgages in the US[13]. Predictable defaults on sub-prime mortgages were only the trigger in a story that began decades ago with legislative changes that deregulated the financial industries to remove regulation and create loopholes. Passing these laws allowed the financial derivatives to become one of the largest unregulated insurance industry on the planet. An unregulated insurance industry rarely functions in crisis.

Bursting housing market bubbles, especially in the US, raised fears that financial “assets” had been poisoned by the mortgages in these credit derivatives. The toxic assets were called Collateralized Debt Options or CDO’s collateralized by, among other assets, houses whose value (a small percentage of the mortgage) were also dropping. Fear pulled the trigger and resulted in the partial collapse of that house of cards we call the credit derivatives market. 

These opaque credit derivatives (essentially mixes of repackaged loans) were toxic because they contain elements that in some cases had little value. In the early stages of the economic downturn, many of these elements were non-prime mortgages which were packaged up and sold on as part these credit derivatives. Defaults on the mortgages made the “assets” toxic. The opacity of the complex derivatives caused fear, the markets froze causing a crisis of illiquidity which has had knock on effects in the banking industry, the stock markets and now the “real” economy.

The profit in the unregulated nature of these credit derivatives made them attractive. On the other hand their complexity and opacity lead them to be described by Warren Buffett as "financial weapons of mass destruction"[14]. But who built these weapons? To answer that question one has to look at the people behind the legislation which deregulated certain hedging such as The Commodity Futures Modernization Act of 2000 (CFMA, H.R. 5660 and S.3283) and The 1999 the Gramm-Leach-Bliley Act, which partially repealed the 1933 Glass-Steagal act (an act also responsible for the establishment of the FDIC). One could do worse than take a look at the career of people like Phil Gramm, chairman of the senate finance banking committee who proposed both Acts.

Asking journalists to describe derivatives is notoriously difficult, in part because they do not make sense. Instead, the less sophisticated tabloids paint a picture of poor renters in the United States tricked into becoming homeowners at the end of an extraordinary US housing bubble. The FED is to blame for the housing bubble because of tax incentives on mortgages combined with historically low interest rates since the Dot Com bust in 2002. In effect these turned a stock bubble into a housing bubble. Rather than explain what exactly toxic securities are. Column ink paints heart-rending stories like those of the end of the last big tech bubble where mothers put their children’s education funds into tech-stocks and lost most of it. Meanwhile the stories on unwise investments in bricks-and-mortar as kept far away from the real estate classifieds.

In early 2007 economic supplements echoed the common knowledge that “house prices never fall”. When the fat-cat financial bubble showed its first public signs of bursting in August 2007, journalists were forced to pen a new reality. Economics writers bandied around delicious financial terms like “sub-prime”, a polite term for poor and unemployed clients borrowed from the insider terminology of the now defunct mortgage underwriters.

Dancing around the manifest bubble in international real estate epitomized by the US, Spanish and Irish real-estate markets, these columns were filled with characterizations of retail mortgage lenders like perverse car salesmen in bad suits conning uneducated buyers for large sales commissions. Here was the bad guy that had poisoned the healthy sophisticated financial system. If the cat dies, blame him!

Growth Rates and The Real Story
Toxic securities are complex derivatives with names like credit default swaps (CDS’s) and Collateralized Debt Obligations, (CDO’s)[15] —so called structured finance products. CDO’s are packaged up and sold off by investment banks to the highest bidder used to be rated highly secure (AAA) from the complicit ratings agencies run by managers of the so called hedge-funds. The funds have changed in nature in the recent past. They have less to do with hedging and much more to do with what John Kenneth Galbraith called “innocent fraud”[16]. The hedge funds have been creating “value” on a very grand scale. They have invented “financial instruments” willy-nilly since the 1980’s completely free from market regulation both off- and on-shore.

In layman’s terminology, the creation of financial instruments is the invention of value from hidden parts of little or no value. This has been done on such a massive scale that the resultant financial bubble (the so called unregulated derivatives market) has the approximate nominal value of the order of $200 Trillions in the US alone and that does not include investment banking.

Numbers in trillions are difficult to fathom. However, the gravity of the situation is evidenced by two salient facts. First, there are no more independent investment banks on Wall Street. They have all gone bust and have been rescued by the US government, and/or bought out or have transformed themselves into regular banks subject to more regulation but with vital life support systems offered by the FED to save them from going under. Second, the planetary unregulated derivatives markets have a nominal value larger than all the world’s stockmarkets combined.

In the launch of the 2008 Global Financial (in)Stability Report[17]: Jaime Caruana, the councilor and director of the Monetary and Capital Markets Department of the International Monetary Fund said: “There is now an acute awareness of the fragility of confidence in financial institutions and markets. The global financial system is going through a process of de-leveraging …”

De-leveraging means losing money, it means banks that have a hard time bringing the mark-to-market asset back to a minimal 8% of the nominal value of their complex debt portfolio. There are two ways to do this as the toxic assets are being written off, either get more money in, as deposits for example, or write off the debt obligations that will never be paid. In short, the bubble needs to burst; the question is if it shall deflate or whether it will be a blowout. If orderly deflation is possible by massive intervention and global coordination even including tax havens, it may be possible to prevent a massive implosion of the banking system. If not, then the world will not end in a bang but massive write-offs will mean the shrinking of the financial system that shall have its consequences on a global scale.

Either way this financial innovation needs to be controlled or stopped. In a debate published in the UK Economist magazine, Joseph E. Stiglitz speculates on the future after the correction:

“… anyone who has seen America’s political processes at work knows that after Wall Street gets its money, it will begin fighting the regulations. It will say: Government must be careful not to overreact; we have to maintain the financial markets’ creativity. The fact of the matter is that most of that creativity was directed to circumventing regulations and regulatory arbitrage, creative accounting so no one, not even the banks, knew their financial position …”[18]

[1] http://www.economist.com/research/Economics/alphabetic.cfm?letter=A#animalspirits
[2] measured in percentage terms
[3] http://www.cboe.com/Framed/Framed.aspx?content=http%3A%2F%2Fwww%2Ebigcharts%2Ecom%2Fcustom%2Fcboe%2Dcom%2Fcboe%2Easp%3Fsymb%3Ddjia§ionName=SEC_TRADING_TOOLS&topControl=/templates/Framed_Content_Control.ascx
[4] www.independent.co.uk/news/business/comment/business-view-gordon-brown-the-imf-needs-you-and-britain-needs-you-to-go-572294.html
[5] http://www.ft.com/cms/s/0/ddc53e22-94d3-11dd-953e-000077b07658.html
[6] http://www.ft.com/cms/s/0/1a0b47a8-880b-11dd-b114-0000779fd18c.html
[7] THE WEEKEND INTERVIEW, Oct. 18, 2008, Anna Schwartz, Bernanke Is Fighting the Last War
'Everything works much better when wrong decisions are punished and good decisions make you rich.'
By BRIAN M. CARNEY, Wall St. Journal: http://online.wsj.com/article/SB122428279231046053.html
[8] http://abcnews.go.com/Business/Economy/story?id=5932586
[9] Various riders were added to the $700bn. TARP bill in order to win back votes for the measure which is the largest single US government expenditure in history. Republican House Representative Spencer Bachus was quoted in the New York Times as saying: “The bill that came over from the Senate includes a series of pork-barrel projects that are simply unacceptable not only to me but to the American people,…”, http://dealbook.blogs.nytimes.com/2008/10/03/house-to-vote-on-rescue-proposal/
[10] http://www.cepr.net/index.php/op-eds-&-columns/op-eds-&-columns/the-return-of-great-depression-economics/
[11] http://www.amazon.com/Three-Trillion-Dollar-War-Conflict/dp/0393067017/ref=pd_bbs_sr_1?ie=UTF8&s=books&qid=1204232422&sr=8-1
[13] Though sub-prime is a US term, many other countries weakened their protections in lending practises for mortgages thus poisioning their credit markets, too, with unpayable debt.
[14] “Weapons of mass financial destruction, Le Monde Diplomatique”, Gabriel Koldo: http://mondediplo.com/2006/10/02finance
[15] or CDO’s of CDO’s commonly referred to as CDO2
[16] Banks got burned by their own fraud; John Kay, Financial Times Oct. 14th http://www.ft.com/cms/s/0/12ade22e-99fc-11dd-960e-000077b07658.html
[17] World Economic and Financial Surveys: Global Financial Stability Report: Financial Stress and Deleveraging Macro-Financial Implications and Policy, October 2008 http://www.imf.org/external/pubs/ft/gfsr/2008/02/index.htm
[18] Economist debate, Con: Joseph E. Stiglitz: “Would it be a mistake to regulate the economic crisis heavily alter the crisis” http://www.economist.com/debate/index.cfm?debate_id=14&action=hall

Posted by Tony Phillips at 04:24 PM | Comments (1)