Page 1 of 2 Rules, leverage and the fall of man
By Julian Delasantellis
There is a story of an 18th century Frenchwoman, an enthusiastic and purposeful
fan of the French Revolution's Reign of Terror, and of that peculiar sport's
head cheerleader, Madame de la Guillotine. At the 1793 execution of Marie
Antoinette, like a Los Angeles Lakers fan sharing courtside seats with Jack
Nicholson and the rest of the beautiful people, she bragged at how near she was
to the action.
"I was standing so close," the fan beamed. "I could hear the whisper of the
axe."
Fast forward to today, and even though I was eight time zones away, on late
Wednesday afternoon I heard the whisper of the axe
come down on a third of a century of the history of the capitalist world - the
era of deregulation.
From the Iliad to Britney Spears' Crossroads, the vast majority
of the human race's dramatic, and even comedic, productions, follow what is
called the three-act pattern - the introduction to the characters and the
challenge they face, the characters working through the problem (that could be
Ulysses fighting his way back to Ithaca after the Trojan War in the Odyssey, or
Seinfield finding a place to urinate in a car park), and then, finally, the
successful (unless it was the 1970s) resolution to the problem and conclusion.
Late Wednesday and early Thursday, the global financial crisis that originated
in the market for mortgage obligations based on subprime borrowers ticked over
to Act III - the conclusion. The problem has passed from the purview of
economics and markets to that of government and its statutory ability to write
really big checks.
Really, really big checks.
I could hear the shiny blade's icy fall on Wednesday afternoon, as I signed on
to read the Financial Times. Most of the media coverage for that day centered
on the declines in world stock markets that had occurred or were still taking
place. The Dow Jones Industrial Average closed down 450 points that day, after
dropping 508 on Monday.
Still, the stock market rout was nothing compared with what was going on in the
credit and debt markets. Wednesday saw the process by which the capitalist
world distributed funds from private savers to private borrowers,
intermediation, essentially collapse. Not even the most previously considered
highest rated and safest borrowers could then be trusted to still be there and
in business the next morning. Instead, the only thing that could be trusted
that day was US Government three-month Treasury Bills, which, the FT reported,
experienced their greatest increase of price, indicating a massive, frenzied
demand to reduce exposure to the unguaranteed private sector, since the
"Blitz", the German bombing campaign of London intended to prepare the way for
an invasion in 1940.
I thought about that for a while. No alien spaceships, as in Independence Day,
had suddenly appeared over Wall Street or the City in London. This was a threat
entirely of the system's own manufacture. Still, the problem had grown so large
and menacing that the markets were now equating it with the threat posed by
Hermann Goering's waves of marauding Heinkels and Stukas 68 years ago.
Something had to be done.
Thursday morning, I took my wife to a doctor's appointment. Playing on the TV,
in front of the same dozen dozing senior citizens that seem to rotate around
and through every one of the many medical offices I have visited this year, was
the same old American game show that has probably been on in this office for
the last 50 years. I changed the channel to business channel CNBC, and they all
woke up and turned their chairs to be in front of the set - the only upbraiding
I received for the move was in not turning the sound higher.
Mid-day West Coast time, and in the distance the bugles of the cavalry's rescue
could be heard. Charles Gasparaino of CNBC was reporting talks on an imminent
rescue plan that would essentially buy from the portfolios of the major
investment and commercial banks the ever-depreciating mortgage backed
securities whose retrenchment in value was pressuring the ability of the
financial system to collateralize new loans in areas far removed from mortgage
finance.
CNBC quickly touted the fact that their salivating screwball savant of stocks,
Jim Cramer, was pushing this idea in July. He must have been reading this site,
for I did the same in my March 6, 2008, Asia Times Online review of the first
year of the subprime crisis,
And the band played on.
These days the American public understands so little economics and finance that
listening to media types trying to describe these events is a lot like hearing
the proverbial blind men trying to explain what an elephant is through touch.
The most common explanation for the cause of what's going on here is that
"people borrowed and bought more houses than they can afford, and now have to
be bailed out when they can't pay the loans back".
By connecting these events to the tendency of people, as Hannibal Lecter put it
in The Silence of the Lambs, to covet what we see every day, it puts a
face on the crisis, namely, it's the fault of "that SOB Bob, who built that
700-square-meter house on a hill that blocked our view, and who at the
neighborhood Christmas party got drunk and made a pass at my wife".
Whatever Bob's virtues or vices, he's not the cause of what's going on here. As
I've said here many times, the crisis may have germinated with borrowers like
Bob, but it only grew to its full terrifying flower when the mortgage-backed
securities based on Bob's loan payments arrived on Wall Street. There they got
sliced and diced, chopped and pureed, finally, used as collateral for up to 20
or 30 rounds of successive new borrowings and lendings.
That is in no way hyperbole - we are now learning that many Wall Street
investment banks had made loans, were "leveraged", in Wall Street lingo, at up
to 40 times their actual cash balances. If Bob's $1 million mortgage had been
used as the basis for $40 million of other loans, put a million Bobs in the
system unable to pay their mortgages, and you have the current crisis.
On Thursday evening, according to Senator Christopher Dodd of Connecticut, US
Treasury Secretary Henry Paulson briefed Congressional leaders on the
developing plan, said the financial markets would collapse "within hours"
without rescue. That got everybody's attention.
On Saturday morning, the plan was delivered to Congress. In contrast to what
you might think, and what is usually the case regarding financial legislation,
this one was simplicity itself. At just three pages long, it is basically a
request, probably closer to an order, to the Congress to give the Treasury
US$700 billion (with government standard operating procedure being to always
underestimate program costs, you can just imagine what Treasury's real
estimates for the cost of this will be) and all will be well with creation.
Amazingly enough, the fear stalking the halls of Congress, that of being blamed
on election day for financial holocaust, was so great that at least as the
weekend began, it looked like the request would gain approval fairly
effortlessly, past the egos of legislators who regularly delay assistance to
destitute widows and orphans if only because the supplicants' advocates had not
sufficiently bussed the solons' rings and posteriors.
As usual, the devil resides in his usual, fully paid up residence - the
details.
Many commentators are comparing the process that the Treasury wants to commence
to the Resolution Trust Corporation (RTC) , the entity set up to dispose of the
properties and assets acquired by the US government in the savings and loans
debacle of two decades ago. This comparison is partially right in that the end
process, the auctions of assets, will probably resemble the RTC process, but
the method by which the government acquires the assets will be far different.
Basically, once (if) the bill passes, there will be forthcoming on Wall Street
some manner of "bring out your dead" moment, by which Paulson will traverse the
sad streets of Lower Manhattan, entreating the great houses of money to throw
the stinking, rotten carcasses of their mortgage-backed securities into his
pushcart. The $700 billion is what Wall Street, and other of the world's great
houses of money, whether they're located on the Street or not, will receive in
exchange for these securities.
This crucial first step, the actual acquiring of the assets, was not necessary
for the RTC; the government already owned the assets through the bankruptcy of
the banks that previously owned them. These assets are going to be acquired by
the Treasury through a sale - that, of course, means a sale price.
In fits and starts, the banks have been trying to sell off small portions of
their MBS to various hedge fund and private equity groups this past year (see
Crisis? What crisis?, Asia Times Online, April 16, 2008), sometimes at
prices as low as 20 cents on the dollar of the asset's face value. What is very
much currently unknown is what average purchase price, as a percentage of asset
face value, will the Treasury offer to the banks. Too low, say a nickel on the
dollar, and the banks won't bite; they'll try to ride through the crisis with
the paper on their books, hoping it eventually pays off at face value, or par.
This option would be made more attractive if the Treasury can continue to keep
the mad panic out of the markets by buying up enough paper from other banks, as
well as with its new, comprehensive ban of short selling in the financial
stocks. In economics, this is called the "free-rider" problem, when one
institution benefits without cost from the sacrifice of others. If enough banks
hold on to their MBS thinking that other banks will sell out cheap and do their
work for them, we could be back right where we are now in a few weeks time,
maybe even, and here Washington really quakes, in the days and hours
immediately preceding the election on November 4.
What if the Treasury swings to the other pole, in that, in an effort to get
past the crisis once and for all, they pay the banks too much, say, 50 cents on
the dollar? The banks will rush to get in on that deal, but I just can't
believe that the Treasury is using a 50 cent purchase price in its $700 billion
calculation. In that case, those who say that this part of the bailout will
wind up costing well over a trillion, in addition to the $900 billion the
government is already on the hook for in the financial crisis, are absolutely
right.
Another factor that will be central to the success or failure of this
initiative, and to how much it will eventually cost, will be the question of
just what the Treasury gets to buy. Like any smarmy used-car dealer, the banks
know full well which of their MBS are creampuffs and which are lemons, which
will get paid back, and which wouldn't get paid back even if the borrower wins
the lottery and uses the proceeds to buy a money printing press.
The latter of that duo is what the banks would most like to get rid of, and
what the government would least like to get stuck with. These would be
devilishly hard to sell back to investors should the private secondary market
for mortgages regain its footing in a few years. This pricing versus quality
issue is what sank the public/private sector "M-LEC" (Master Liquidity
Enhancement Conduit) subprime initiative last fall (See
Subprime Fallout: Save Our Souls, Asia Times Online, October 23, 2007)
and the possibility of the government getting stuck with hundreds of billions
in MBS lemons is another factor that could push the total cost of the bailout
past the trillion dollar mark.
In contrast to these fairly technical issues, what the public wants to know is
who's going to pay for all this. That's the easy part. Drive past any
schoolyard, or even turn your eyes from the monitor to see the little humans
playing with toys on the carpet, and you'll see who's gonna get stuck with the
check from this party.
Since both presidential candidates currently react with indignation and horror
to the prospect of the American government paying its bills on time, these sums
are to be borrowed, put on the country's credit card, added to a rapidly
burgeoning budget deficit. Since the country currently uses far more capital
than that generated by its citizens, who act as if they equate saving with
sodomy because they share the same first letter, that capital is going to have
to be attracted and generated from abroad, primarily from official sources such
as the Chinese, and other central banks of export rich nations.
This generates issues of its own. China's and the other central banks were more
than willing to lend to America in the early years of this decade, when their
economies were growing strongly, and the US deficits were still in the more
moderate, "reasonable" neighborhood of $200 billion-$300 billion. Even without
any of the bailout costs being accrued the US budget deficit was scheduled to
push $500 billion this year (not counting the costs for the wars in Iraq and
Afghanistan, which, even though they cost about $160 billion every year, are
not counted in the official budget statistics); the bailout costs will almost
certainly push the deficit past $1 trillion, either this year or the next.
Will the lenders want to lend that? Will the Chinese people, with their economy
slowing and their urban population now used to a
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