February 24, 2009

The Casino at the End of the Universe


I have referred before to a remarkably prescient book, published some years back, entitled Infectious Greed by Frank Partnoy, which detailed the tenuous world of derivatives and the threat they posed to the world's financial stability.  Partnoy took as a jumping-off place the meltdown of Long-Term Capital Management, that giant hedge fund quietly working its sinister magic in the sylvan quiet of the Connecticut suburbs.  LTCM innovated like crazy and had the inspiration, and genius, of sensing it required the services not of standard issue MBAs, but of math PhDs from MIT and Harvard who could construct the arcane and insanely complicated algorithms necessary for LTCM to optimize its computer-driven arbitrage strategies.  The system couldn't miss, until it missed entirely.


The nightmare, house-of-cards scenario which Partnoy predicted in detail has now actually happened.  Usually these sci-fi disaster movies remain fictional; not this time.  Instead of learning anything from LTCM's game-playing and ultimate implosion, what Wall Street learned was that even in a stagnant economy, where nothing of real worth is being produced, enormous sums can still be earned by playing games with money.  Any common financial...thing, such as a residential mortgage or a VISA card balance, could, with sufficient scale, aided and abetted by millions of side bets, become the stuff of new fortunes.  And so we witnessed (we didn't really see it, and we certainly never regulated it) the massive proliferation of mortgage-backed securities, collateralized debt obligations, short selling, and credit default swaps.  

These all interplayed and interacted; for example, Bank A might bundle together a few thousand mortgages into a pool, and base the issuance of bonds upon them, creating a Special Purpose Vehicle to issue the bond (and to keep the liability off the books of Bank A).  The actual bonds were sliced, diced and parsed into tranches of relative risk: top level (AAA), mezzanine, lower equity, which might be retained by Bank A itself.  To insure the risk involved in these mortgages (and the MBS based upon them), credit default swaps were bought and sold, sometimes by the issuer and purchaser, sometimes by insurance companies such as AIG.  

The swap guaranteed payment in the event of default.  To make it all more fun, there was no requirement that the swap be held by someone with any real interest in the MBS at all; anyone could buy one, thousands of people could place bets on whether the MBS would pay or fail. Then to stack the deck a little further, the playuhs, the Big Boyz, could increase their chances of collecting on their bet the MBS would fail by short selling the underlying instrument to drive down its price.  What made it all the more creative and exciting is that no one regulated the world of credit default swaps. Not the SEC, certainly not the Federal Reserve of Ayn Greenspan.  One can only guess as to their total "notional value;" some people estimate a total value of $1.4 quadrillion, or more money than exists in the world.  Did the United States, in purchasing an 80% stake in AIG, succeed to an exposure for $1.4 quadrillion in swaps?  Hey, I guess we'll find out!

Does any of this actually sound like a process by which one puts vegetables on the table or heats one's dwelling?  I think Thoreau said, in more eloquent words than these, that one should beware of solutions to the problem of living that are more complicated than the problem itself.  I was thinking of this last night as I was watching the PBS "Frontline" special called "Inside the Meltdown" which tried (really tried) to explain what's happened to us. Personally, I don't think it came close.  There were the usual tableaux vivants: the big conference room videos with Bush, Paulson, Schumer, Dodd, Reid, Pelosi, Bernanke sitting around a table, and then someone like Chris Dodd standing in front of a microphone saying stuff like, "When we heard how close we were to a meltdown, the oxygen left the room.  We've got to get this right."

It's all so dramatic.  But it occurred to me (a) the ones sitting around the conference table were the ones who let it all happen and (b) they are entirely the wrong people to fix it.  It's as if these same people sitting around the table were asked to come up with an innovative approach to string theory.  The complexity of the problem is simply beyond their understanding.  The only hope, and it's not much of one, would be to enlist the MIT PhDs who constructed the algorithms in the first place to conduct a seminar for a month or so and to suggest ways to unravel and unwind the puzzles they had constructed.

Instead, the Treasury and the Fed are going to continue down a path of reacting to the latest bad news, without really understanding the underlying origins of the problems they're confronting.  How big they are, how long they might go on.  They are going to treat this enormous financial Frankenstein as if it were the normal outcome of "banking" and "investing," and sacrosanct because, after all, these were all "contracts" freely entered into by capitalists pursuing their trade.  No matter how far the contagion spreads, the U.S. government is going to keep doling out billions, hundreds of billions, trillions of dollars in an effort to stanch the infection.  To keep this enormous Casino at the End of the Universe, these palaces of greed and bad judgment, standing for as long as possible, until they topple over from the rot within.

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