January 21st, 2008

Worldwide crash underway / Price Controls the answer

Posted in Money by ed

(This is very disorganized. Will slowly make it more coherent. The sight of hundreds of billions of dollars worth of securities being wiped out in a single session, in Asia and Europe today, somehow muddles the mind and thickens the fingers.)


1.  Markets in Asia and Europe are absolutely crashing today. The major European indexes down between 5 and 7 percent. Asia between 4 and 5. (Ten percent is usually thought of as a “correction,” and usually plays out across weeks and months.)

Meanwhile the U.S. is idle in respect of Martin Luther King. But the Dow Industrial futures are down over 500 points. (From approx 12,000, with 14,000 the high earlier this year before the stuff hit the fan.)

The Times and general media in general are all careful to place the blame in their headlines on “fears of U.S. recession.” That’s not quite it.

The fear is that financial institutions worldwide are going to take another round of much larger losses as a chunk of bonds much larger than the subprime mortgage bonds get downgraded, go illiquid and begin to fail.


2.  Coincidentally (?):

(a)  the annual conference of the people who run the world at Davos, Switzerland takes place this week; and

(b)  the NY Times Magazine cover story yesterday was “The Education of Ben Bernanke,” about the new US central banker, a quiet fellow who came to the job after decades in Academia with a valise of papers he’d written about how central banks avert and manage disasters.

3.  Big Ben has been loathe to cut interest rates in face of the mounting disaster. Applying his well worked thoughts, he tweaked the writhing monster throughout the autumn, refusing to make the direct and conventional move (dramatically cut the two bank rates the Fed controls), opting instead for small and eccentric experiments in enhancing liquidity.

He doesn’t seem to have realized that the crisis is not simply a liquidity crisis. Rather: brewing insolvency. At banks and insurance companies worldwide.

4.  In a better world — I mean, one without Bush-Cheney — things might have been very different. But the US budget deficits and trashed dollar — effects of six years of redux Reaganomics — means that Ben has to care for the health of the dollar much more than he might have if the more or less flat Clinton budget had continued post 2000.

Why? To please the people in Tokyo, Shanghai, Hong Kong, Singapore, Bombay, Dubai, Riyadh, Frankfurt, Zurich and London who buy U.S. Treasury bonds with foreign currencies. The weak dollar trashes their investment.

And every time Ben cuts the Fed rates the pressure on the dollar worsens.

In a world with a flat Clinton budget, it wouldn’t matter. Ben could cut rates back down to post 9/11 territory — even Japanese territory (1% or less) — and we’d still have no trouble finding the (much fewer) Treasury customers we needed.

But that’s not the world we live in anymore. Treasury investors using foreign currency have been burnt badly by the dollar’s fall since Bush took office and have been making noise for two years about cutting back on dollar-denominated investments.

If Ben slashes his rates, those people may hasten their steps away from the dollar into gold and swiss francs and euros and pounds sterling and … rubles? Yes, the ruble is now a hard currency. Our Man Vlad’s been working hard.

That’s one big meta-reason, then, one suspects, that Ben has been loathe to cut throughout the fall. Who’s going to pay the Pentagon if our Asian creditors fade their trade? (The Fedspeak never speaks explicitly of such things, of course, but one suspects nevertheless.)

So one must sympathize with Ben a bit. Between a rock and hard place.

Nevertheless, history will record that he fiddled all fall while Rome, yea, verily, the world entyre, caught fire. bernankethumbnail.jpg China’s so recently rocketing market has been in free fall for a month. Nobody wins in worldwide recession complicated by a frozen and insolvent banking system.

5.  Causing the US recessionary pressure, at bottom, is the loss of equity in houses on Main Street nationwide and the credit crunch in money centers worldwide.

The latter was triggered by the surprisingly broad and deep US mortgage bond failures (caused by the all but unprecedented drop in housing prices), then exacerbated by a factor of five or ten by the consequent lack of confidence in the methods eager beavers use to evaluate those and all other complex “structured-finance” bonds.

6.  “Structured finance” is the most general term for the complex derivative bonds that blossomed in the world with the advent of personal computers and Excel. Mortgage bonds, credit card bonds, auto loan bonds, David Bowie royalty bonds — all these are “Asset Backed Securities”, a large general class within structured finance.

CDOs are bonds that are based on large diversified pools of other bonds, often ABS. CMOs are based on large pools of mortgage bonds. CLOs are based on large pools of loans (loans often used to float Leveraged Buy Outs). SIVs are conduits that often have ABS as collateral and which issue “commercial paper” (very short term cash bonds/loans that financial institutions use to meet day to day cash needs).

All these and more are “structured finance” instruments. In contrast to the old fashioned corporate bond: eg, General Motors needs money, so it pledges its good name and sells IOUs. There are no secured “assets” backing these bonds. Just GM’s word.
The lack of confidence in the methodologies by which banks and rating agencies evaluate s-f bonds is a huge problem and has persisted since June, when two Bear Stearn funds specializing in mortgage bonds went belly up. warrensad1thumbnail.jpeg It should not have happened — ie, ABS rated AAA should not have failed as badly as those rated BBB-, but it seems they often did. Somehow the rating scheme failed to model reality when the pressure came on the underlying assets.

7.  Last week it became headline news that the bond insurers are likely to default. That is, they simply do not have enough money to meet the mounting mountain of claims on the (mostly AAA) s-f bonds they insured across the past decade or so.

The rating agencies (who certify the insurers’s ability to meet their obligations) last week finally went public about this, even though as early as October the word was out on the Street. The agencies put the ratings on watch, then lowered them — then began downgrading the s-f bonds that the insurers insure.

This (along with the new reports of losses at the banks, and very bad reports on the Christmas season from the retailers) is what sent the US markets tumbling last week. And what’s crashing Asia and Europe (and now Canada and Latin America) today.

As I wrote here in October, if the bond insurers fail, a universe of bonds much larger than the subprime mortgage bonds will have to be downgraded, which will lead to much more paper losses (“writedowns”) across an even larger array of financial institutions, many of which will be compelled by their covenants to try to sell the wounded bonds, making them even less attractive and more hard to sell, enhancing the downward spirial.

Losses at banks, insurance companies, pension funds, etc will move from the low hundreds of billions into the trillions.

At which point the “free market” confidence game ends, because the banks, insurance companies, will have negative balance sheets. More liabilities than assets.

Chuck Prince the cavalier CEO of Citigroup, recently fired, had compared the game in July to musical chairs, with a wily grin, acknowledging that when the music stops things may be grim, but insisting that until then he’d just keep dancing.

The music has now stopped. Citi reported almost $20 billion in losses last week. And if the bond insurers fail $20 billion will be a drop in the bucket.

Jumpin’ Jersey Jim Cramer noted a month or so ago that when everybody is insolvent, nobody’s insolvent. Because the music has stopped and the game has ended. That’s where we’ll be. Maybe before things wrap up in Davos at week’s end.

8.  There may be no precedent for this avalanche.

1907 was a system-wide failure but largely contained in the U.S. Today’s is truly global.

The US system was saved (the story goes) in 1907 by the person of JP Morgan, who got a few pals together in a room and came out with guarantees that supported the system til it got back on its feet. The controversial new central bank, the Federal Reserve System, was created in 1913 so that (story goes) such things would never happen again.

The depression of the 30s serves as something of a precedent in that its perhaps primary cause was a severe and protracted credit drought, a misguided reaction to the panic of the 1929 market crash: the central bankers of the day were armed with the wrong theory. Austerity (for the poor) was their cure. It turned a crash into the Great Depression.

9.  Given today’s global crash, everyone will (again) be expecting the US central bank to slash its rates tomorrow morning before the bell. Will Ben finally comply, or stick to his theories well honed across decades in the Ivory Tower?

He seems a very stubborn theorist.
benb.jpg Perhaps red faces at Davos may provoke a change of mind.

Not that cutting Fed rates will solve the problem. It will help stabilize things, however.

10.  To solve the problem something very pre-80s will have to be done, now that the Free Marketeers have shit the bed.

EITHER: the governments will have to buy the bond insurers or otherwise assume reponsibility for that task. With “guarantees” of some sort perhaps. (Joltin’ Jim suggested this past Friday gov’t guarantees of 50 cents on the dollar.)

OR: A price control regime will have to be instituted re the wounded bond classes.

I suggested the latter here in August, to polite chuckles from the few knowledgable readers who glanced at the site.

11.  Price controls would allow the bleeding financial institutions holding the wounded bonds to mark (ie, evaluate for balance sheet purposes) and hold them on their books at a level well above the current near-zero market value that the crisis of confidence (in methodologies) has produced.

In other words. A Man in a Big Suit tells the world: Okay, you got credit card bonds rated AA- at issuance? And nobody wants to buy them? Okay, for the next two years (?) you can mark them at 62 cents (face value $1.00) on yer books. And if you want to sell’m you can’t go under 62 cents.

This would allow the wounded bonds to remain on the books at less than catastrophic marks, which would stop the panicked bleeding each quarter as the banks report tens and scores of billions of paper losses due to frozen markets.

And this would allow the wounded bonds to simply live out their lives, paying most of the interest they’re expected to, one imagines, and returning much more of their principal at wind-up than the current near-zero market values suggest.

During this enforced valuation period things would stabilize, fiscal and monetary policy would begin to heal the housing disaster and other economic underlyings.

The banks would start trusting each other’s balance sheets, and thus start lending to each other, again. And the crippling anxiety of waiting to see how many scores of billions Citibank and Merril will rack up next quarter will go away.

This would be mind-blowing for most “market participants” and “professionals.” It goes against everything their TVs taught them as kids and teenagers during the 80s. The last time we had price controls here was during Nixon. But it is now publicly clear that there is no market cure for this crisis. And if the people in D.C. don’t take their hands out of their pockets everybody’s going down.

Remember the scene in It’s A Wonderful Life where suddenly people are streaking through the street, heading for their banks. That’s what’s coming, folks. Do You Know Where Your Money Is?

I don’t suppose this is very clear. Will come back later and try to make it more so.

My glass is half empty — waiter!?


Ah. As night falls in New York, Tuesday begins in Asia, with an even more tumultuous drop. At 11:20 pm EST in New York, the Hong Kong market is down over 10%. !!! After five percent yesterday.

And the major index for the Indian market is down 11.5% and trading has been halted. The game is over. The Free Market is again dead.
bombaytues.JPGPeople watching the tickers scream in Bombay Tuesday morning

The problem began in the U.S. and Wall Street is the heart of the securitization world (although London too does a ton of business). The whole world is watching and waiting for Ben and Hank to do something.

I’ve often wondered, since the 9/11 attacks, when the Great Transit would occur and how — the great movement in which Wall Street would cease to be the financial capital of the world, to be replaced by the Tokyo-Hong Kong-Shanghai circle. Would it happen with a bang or, more likely it seemed, a whimper?

(After 9/11 business decreased in New York and increased in Houston and Charlotte, N.C. An interesting Yankee-Cowboy angle on the attacks. If another bomb goes off in New York, Houston bankers will benefit.)

If the Americans, having created the current global crisis, drop the ball, and continue to allow the Free Market to writhe and belch, perhaps this will prove the watershed event in the Great Transit. Are the Americans going to let several trillion in US bonds go down the tubes? What good are they, then, if you’re sitting in Peking?


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  1. ed says:

    Naked Capitalism (always excellent) has a thread about the bond insurer closest to bankruptcy:


    I posted a comment there.

    January 22nd, 2008 at 12:20 am

  2. ed says:

    SO!  On Tuesday morning Big Ben takes the big step, in the pre-market. Cuts 75 basis points (three quarters of a percent), the biggest single move since 1982.

    Good for Ben. Dow opened over 400 points down anyway, in wake of the carnage in Asia and Europe the past two sessions. Then wandered up to close down single digits or so.

    Also Ambac (the 2nd largest and most distressed bond insurer) reported its atrocious results for prior quarter, but said they were not going to fold or discontinue writing new business and are talking turkey with several possible “strategic partners” as a way to fix their wagon. An analyst commented, after listening to the conference call:

    “In retrospect, insurers wish they’d never heard the term structured finance, much less written the business,” said Donald Light, an insurance analyst at Celent, a consulting firm in Boston.”
    That’s right.  The bond insurers spent most of their lives insuring municipal bonds.  Staid, solid business.  They got into insuring the top tranches (rated AAA) of ABS and CDOs since the advent of Excel and high-tech securitization (which began in the late 80s, flourished in the 90s and went berserk post 9/11).

    But if indeed a white knight comes through for Ambac, and something similarly capitalizing is done quick with MBIA, then the threat of a great tsunami of downgraded AAA s-f bonds recedes, it would seem. The insurer on the brink of bankruptcy last week, ACA, has been given an extra month by regulators to get its stuff together. Muddling through, in short — the only way to go when the Market s__ts the bed.

    So. Pending new disasters, there’s a sense that — even though recession is already here — the financial system may avoid complete meltdown.  Specters of insolvent banks and insurance companies seem to fade.
    Now was that so hard, Ben?

    January 22nd, 2008 at 10:31 pm

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