Page 1 of 2 US Fed's move is the bigger problem
By Julian Delasantellis
It couldn't always have been like this. No, the country today would be a far
different place if across the span of American history had the nation
constantly chosen to focus on the most picayune of arcane and unimportant
irrelevancies, as it's doing currently with the AIG bonus controversy, instead
of on matters with some actual import.
It's early in the evening of June 5, 1944 - the day before the D-Day landings
in Normandy, in Supreme Allied Commander Dwight D Eisenhower's Goodge Street
Headquarters in London. The general
is addressing his senior staff.
"Men, we are at a truly momentous
crossroads in history. Tomorrow we commence America's crusade in Europe,
wherein the New World, fired by the tradition of liberty and justice it
inherited from the old, returns to liberate the Old World from the most
barbarous brand of tyranny and injustice ever seen by man. We must not fail; or
falter, we must ... "
"Excuse me General, but we can't invade tomorrow."
"Can't invade? Why? Will the weather hinder our paratroop landings?"
"No sir, it's not that?"
"Have the Nazis moved Panzers to Caan?"
"No sir."
"Well, what is it man?"
"It's our tanks! They don't have cup holders! We can't invade France with tanks
that don't have cup holders!"
And as a two-year debate is
initiated over whether the cup holders should be adjacent to the tanker's right
or left knee, the Germans construct their atomic bomb, go on to win the war.
"For want of a nail ... the battle is lost" an old verse goes, here, for want
of a cup holder, the Nazis would have conquered the world.
At occasions like the present, the American people act much like the dyslexic
idiot savant Raymond Babbitt in the 1988 movie Rain Man. He couldn't
shake a monomaniac fixation on the TV show People's Court or the alleged
superiority of his K-Mart underwear; America can't seem to lose its fixation,
its rage, over the issue of the US$165 million of bonuses granted to members of
the American International Group (AIG) financial products division (AIGFP), the
sector of the 90-year-old company that so mismanaged the writing and trading of
the newfangled financial product called credit default swaps ( CDS) that the
company has been forced to accept $180 billion in Federal Reserve and US
Treasury largesse since last autumn.
At a congressional hearing on Wednesday, current AIG chief executive Edward
Liddy said he had received a letter advocating that the senior officers of the
company be strung up with piano wire - perhaps one of the people who held on to
the stock as it declined from its 2001 highs of just under $104 to its lows
last month of $0.33 was a music teacher. Another called CNN and said that the
company's directors should be shot; who cares if the network can easily find
out name-and-address information on every toll-free call it gets and report
such information to law enforcement? One observer was more sedate, suggesting
that the bonus receivers follow Eastern tradition and commit seppuku,
Japanese ritual suicide - then again, this came from an actual 28-year serving
US senator, Republican Chuck Grassley of Iowa.
About the hearing itself little needs to be said. I think it most reminded me
of the scene in the Iliad, where Achilles exacts his vengeance after the
slaying of Hector.
On this he [Achilles in the Iliad; committee
chairman Barney Frank at the hearing] treated the body of Hector [Liddy] with
contumely: he pierced the sinews at the back of both his feet from heel to
ankle and passed thongs of ox-hide through the slits he had made: thus he made
the body fast to his chariot, letting the head trail upon the ground. Then when
he had put the goodly armor on the chariot and had himself mounted, he lashed
his horses on and they flew forward nothing loth. The dust rose from Hector as
he was being dragged along, his dark hair [actually, Liddy's was white] flew
all abroad, and his head once so comely was laid low on earth, for Jove had now
delivered him into the hands of his foes to do him outrage in his own land.
Thus was the head of Hector being dishonored in the dust.
Everybody
likes simplistic, public passion plays of good and evil - where would the Maury
Povich tabloid TV show, now the Maury show, be without DNA tests
or lie detectors? But the real scandal here is not the $160 million in AIG
bonuses - it's the $180 billion in AIG bailouts, and, unfortunately, very
little is being discussed about them.
If you are a leftist never much enamored of what was up until then the dominant
political economy philosophy of market suprematism, September 2008 must seem
like something of a blur to you, like the mad, happy, chaos that precedes a
girl's wedding.
First Fannie and Freddie went down the tubes, then, in the space of a few hours
on a weekend, Merrill Lynch was consumed by Bank of America and then Lehman
Brothers went bust. By the end of the month, market capitalism's reigning chief
lackeys, George W Bush-appointees Ben Bernanke at the Federal Reserve and
Treasury secretary Henry Paulson were begging the US Congress for $700 billion
or so - what later became the Troubled Assets Relief Program - of taxpayer
money to pull the financial system out of the mess it had created for itself.
Less noticed at the time was what was happening with the American Insurance
Group, or AIG. There, in exchange for stock warrants representing 79.6% of the
company's equity, the Federal Reserve Bank agreed to provide AIG with $85
billion; further cash injections by the Fed and Treasury in October, November,
and just a few weeks ago put the total amount the government was on the hook
for with AIG at $180 billion.
Clearly, AIG needed a whole lot more work on its business plan.
Last summer (see
Jaws close in on Bernanke, Asia Times Online, July 16, 2008), I
described how, where once US mortgages were ultimately guaranteed by
government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, the
mortgage guarantee function during the glory days of this decade's credit boom
up to 2007 was mostly performed by something called credit default swaps (CDS),
private, unregulated, non-exchange traded derivative instruments that allowed
two parties to come together to place bets on the health of a bond, the company
that issued it, even the sovereign debt of whole countries.
What we are gradually learning is just how central CDS became to the great
expansion, and now deflation, of the credit bubble. As the securitization craze
deepened and expanded, as everything from loans for houses, cars, office
buildings and credit cards got rolled up and then sliced off into ever- and
ever-larger successive rounds of debt issuance, CDS were always there,
providing the participants in this market the false sense of security that
whoever was on the other side of the debt security they had just bought or sold
could fulfill their commitment to make good on their obligation. In essence,
the $62 trillion market in CDS became the enablers of the entire shadow banking
system that provided the liquidity for the whole real estate and other asset
boom.
But it's not like there was not even more opportunities for mischief. CDS
betting on a company's decline could be bought for very little, if any, initial
investment in this non-exchange traded market. Many are saying that much of the
crashing decline in the shares of the financial system occurred when people
bought CDS that would increase in value if a company foundered; whoever was the
market maker on that side of the trade would, if at all prudent, enter the
market to either short the stock or buy its puts - thus, a very small initial
investment could have a large and wholly disproportionate effect on the stock
price.
On the other side of the trade, the selling of CDS has a payoff profile much
like that of selling options - an up-front payoff received for the seller
bearing risk. If you do this on an established exchange you either have to put
up an initial margin to prove that you can fulfill your part of the deal if it
turns against you, or have an underlying ownership of the stock that roughly
corresponds to your covered call option position.
CDS were totally unregulated; one could sell and sell and sell them for premium
- as AIG did with CDS on the mortgage-backed securities that came out of the
subprime boom - and just hope that the prices of the underlying mortgages, and
the real estate that backed them up, held up.
If they didn't, it's a mad dash to find Ben Bernanke's phone number.
The free-market advocates of this system, most prominent among them former
Federal Reserve chairman Alan Greenspan, blessed this system, for it seemed to
allow risk to be transferred from those who didn't want it to those who were
comfortable with it. However, once this system was utilized to make it appear
that it was much safer to issue and hold much higher levels of debt than was
previously considered prudent, that logic was turned on its head. As risk got
shuffled and dealt around like playing cards, what financial regulators did not
realize until it was too late was that the total amount of risk the system was
bearing was, if anything, exploding.
At the center of it all was AIG. The essence of insurance is the measurement of
risk - that's why a teenager with a Corvette pays a lot more in car insurance
premiums than a grandmother with a station wagon. AIG thought that this
experience provided background in pricing CDS risk.
They weren't even close. In exchange for premium, and not necessarily a lot of
premium., they sold every CDS they could beg borrow or steal. As Gillian Tett
put it in the Financial Times:
On paper, banks ranging from Deutsche Bank to Societe Generale to
Merrill Lynch have been shedding credit risks on mortgage loans, and much else.
Unfortunately, most of those banks have been shedding risks in almost the same
way - namely by dumping large chunks on to AIG. Or, to put it another way, what
AIG has essentially been doing in the past decade is writing the same type of
insurance contract, over and over again, for almost every other player on the
street. Far from promoting "dispersion" or "diversification", innovation has
ended up producing concentrations of risk, plagued with deadly correlations,
too. Hence AIG's inability to honor its insurance deals to the rest of the
financial system, until it was bailed out by US taxpayers. "
In
other words, risk, far from being diversified across the world, was highly
concentrated, in AIG's computers. This would be a far more productive focus for
the public's outrage than the bonuses, but there's no investigation of this, as
opposed to the bonuses, which all have a face and, probably a very exclusive
address.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
