March 23, 2009

The Financial Crisis, A Pathological Report

Anyone deeply interested in the nuts and bolts of the financial crisis, including a pretty lucid explanation of the ways in which we have gotten ourselves into one helluva jam, would be well-advised to read the always entertaining Matt Taiibi's takedown of the Wall Street bailouts in Rolling Stone, the URL for which is:

It's utterly hilarious to the extent that it's not absolutely infuriating.  Matt does what the dilettantes of the Brainfart Brigade at the New York Times never do, get on the phone and talk to people who can describe in detail how mortgage-backed securities were devised; how they were sold; why they were created; and how they were insured by AIG at the Casino Division of the (formerly) world's largest insurance compnay  And then, after this indispensable research, Taiibi actually thinks through how the system works and why it has come to the awful pass it has.

I recall that narrow escape we managed a few decades ago when we discovered that CFCs in the atmosphere were destroying ozone.  We reversed that folly just in time to avoid utter catastrophe.  What made it all the more chilling was the subsequent revelation that had the makers of refrigerants decided to use bromine (in molecules termed halons) instead of chlorine, discovering the source of ozone depletion at the point we did would have been too late.  The greater ozone destroying capacity of bromine would have made attempts to ameliorate the situation futile.  And the difference in choice between the two elements had to do with a slight marginal advantage in cost in using chlorine instead of bromine; the fate of the planet hung on this trivial choice.

It seems to me that the United States has probably come to something like such a pass with the current financial crisis.  It's a one-time fix that we may be allowed to implement with the world held in a state of co-dependent pretending along with us as we hallucinate the necessary money to fix the system.  I appreciate the comment of my highly intelligent fellow alum and Erstwhile bandmate of a few days ago about the Treasury/Fed's plan to create money out of thin air by (a) running the printing presses to create currency to (b) purchasing our own T-bills, which I have likened before to an ability to cure a bounced check by depositing a check from the same overdrawn account into the account and claiming "solvency."  The United States is "borrowing" money, in other words, from itself, akin to reaching the roof three feet away by lifting the ladder on which you're standing with your own two hands.

We're the only country in the world, for the time being, who might be allowed to get away with this conjurer's trick, simply because we run the printing press for the world's reserve currency. And now China and Russia are making noises about changing that, which is very, very dangerous and scary, and probably the reason that Nouriel Roubini thinks that gold may go to $2,000 an ounce by this summer.

Chief Wizard of the Brainfart Brigade, Paul Krugman, thinks the whole problem with the banks can be cured by nationalization.  Krugman has never much liked Obama, and takes potshots at him whenever he can.  Krugman, in his once-over-lightly research way, cites the Swedish example as the way to go.  Of course, Sweden has a population of about 9 million, or about the size of the metropolitan area of New York.  By an order of magnitude, its problems in the 1990's are not comparable to what's going on with B of A, Citigroup, AIG, Wells Fargo and the rest of them.  Nationalization, in effect, is what the FDIC does when it takes over an insolvent bank. Krugman is proposing that the U.S. take on banks with deposits literally thousands of times larger than the biggest bank failure the FDIC has ever handled in order to "clean up their balance sheets."  After all, it's what they did in Stockholm; should work here too.

The addiction to conspiracy theories of all branches of the media at this point, mainstream press (while it lasts) and all the hip blogs, leads everyone writing about this situation to assume, automatically and a priori, that the only reason Ben Bernanke and Tim Geithner favor of an outsider's approach to clearing the balance sheets is because they're in bed with the big Wall Street banks.  I doubt this.  Nouriel Roubini (a guy who does not share the conspiracy compulsion of these others, probably because he does a little homework) notes that probably $1.8 trillion in toxic assets infects the books of the big banks.  That's what I like about Nouriel; he uses actual, comprehensible numbers, instead of the qualitative junk Krugman uses habitually. So the question becomes, do you actually have to take ownership of the banks in order to get rid of these debits on the books, or is there a way to leverage federal money to clear the debt? That's what Geithner is trying to do.

Interesting that the Dow jumped 500 points when Geithner and Bernanke announced their plan. Almost as if there are people in finance who don't take all their cues from the Op-Ed pages of the New York Times.

March 22, 2009

I don't know what to say either

I've been perplexed (and bored) by the torrent of uninformed commentary concerning the "financial crisis" in the United States, so much so that I've been unable to formulate any sort of coherent comments of my own. I was finally moved today to say something by the truly dazzling display of stupidity offered up by Maureen Dowd in her New York Times column of even date.  In effect, Dowd accuses the Obama Administration of allowing AIG, that nefarious financial craps table, to shovel money out the 'back door" to Goldman Sachs, other Wall Street "counterparties" and even (gasp!) European banks, such as the Deutsche Bank. Thus, bailout money "intended" for AIG winds up in the hands of outfits with "insider connections" to the Obama Administration or with foreigners.

Well, look: when you were learning to read in school, especially if you had decent teachers, you were taught to "read critically," weren't you?  So let's do that with Dowd.

First, the only intelligent thing I have heard anyone say recently about the state of the U.S. financial system is what Prez O himself said: we got into this mess, mostly, through people doing legal things.  And when you think about it, that's the most frightening aspect of all.  What it means is that the natural, intended consequences of our financial system, for about the last ten years at least (say, from the repeal of the Glass-Steagall Act) have been what we're seeing now. The sorry state of collapse was simply waiting for a big downturn in the value of underlying assets (in this case, the housing market) in order to blow up. And now it has. 

It was legal to bundle up mortgages into bond securities which could be sold here and abroad.  What was not necessarily foreseen was that the underlying "rationale" for this practice was the presupposition that the housing market could only go up; this supported the practice of dubious loans, since the houses could "always be sold" or "refinanced" when the market was better. Was it fraudulent to sell MBS on the theory that the housing market would continue to go up?  It was probably not clear enough to support a 10b-5 action under the Securities & Exchange Act, although many lawyers will try it anyway.

Plus, only the savviest of the insiders saw that minor perturbations within a MBS would sink the whole instrument.  Smart guys like John Paulson, who saw that about a 5-6% decline in the value of a MBS would make the whole thing worthless and unmarketable.  In retrospect, elementary logic supports his analysis.  Say that a group of bundled mortgages of the subprime variety pay on average 8%.  With front-end fees and servicing costs, it makes sense that the pass-through to investors (such as big pension funds and foreign banks) would equal about 6% net.  If the face value of the bond is premised on a 6% return, then one can see that a fairly small failure rate among the mortgages supporting the bond will result in a return less than this notional rate.  When that happens, the bond quickly degrades in value.  If, in addition to this factor, the "tranching" and intermixing of MBS has so obscured which bonds are good and which contain many failing mortgages, then the whole class of security becomes suspect, leading to a dodgy market for the things in general.

Which is where we are.  Because the buyers of these MBS realized they were entering, to a certain degree, terra incognita, they insured the bonds they purchased.  These are the so-called credit default swaps.  AIG ran the biggest business in CDS notes.  The difficulty here was that the federal government (led by such free marketeers as Ayn Greenspan) did not require that purchasers of CDS notes have an "insurable interest" in the underlying MBS.  By analogy, to buy life insurance on a person, one must have some sort of relationship, at the point of purchase, which makes the insured life a matter of personal importance.  A spouse, for example.  If members of the general public were allowed to place bets on the death or survival of anonymous people to whom they had no direct relationship, we would, among other things, encourage the practice of killing-for-hire in order to improve the "odds."  No such requirement existed for CDS instruments. Anyone could bet "pass or not pass" on a MBS bought by someone else.  And AIG wanted all the action it could get, since it considered the premiums free money. It certainly did not retain sufficient reserves, you know, in the quadrillion range.

Thus, the "counterparties" that AIG is paying off, such as those suspicious foreigners, include Goldman Sachs, Bank of America, hedge funds, and the Deutsche Bank either as insureds holding MBS or people placing side bets at the CDS craps table.  This latter category, while legal, was a yawning loophole which has brought the world's financial system to the brink of disaster.

But it has nothing to do with Maureen Dowd's moronic take on the situation. If you want to declare all the CDS contracts null and void, then a plenary conference of all the world's industrial countries must be convened to sort out all the debits and credits of these "financial weapons of mass destruction," the notional value of which has been pegged at $1.4 quadrillion, which is probably even more money than Timothy Geithner wants to commit.