The Rise and Collapse of Wall Street's House of Debt

(Editor – see also Reaping What You Sow: Hedge Fund and Housing Bubble Edition;
No Rich People Were Harmed In Making This Recession;
Sub-Prime Market Earthquake is Felt Worldwide;
On the Conservative Mortgage Crisis Meme;
And, The Yen Carry Trade Unwinds.

To understand the accelerating financial crisis that is afflicting various global markets you have to realize there are two credit creation processes at work in the world today. The first is the traditional one run by the central banks through the commercial banking system. This process has increasingly been shunt aside in the past ten years by a new credit creation mechanism run by the Wall Street investment banks. It is this new lending machine which is now imploding, and which threatens to impose severe economic pain.

There were warning signs from the Federal Reserve itself that this parallel universe of credit creation was running out of control. About a year ago the Fed announced it was no longer publishing its M3 money supply statistic. This seemingly obscure technical matter was actually very revealing. M3 is the broadest measure of money supply and includes corporate and investment bank money stock, as opposed to M1 and M2 which focus on cash and consumer credit. The Fed was implicitly saying it no longer had control over the credit being created through the investment banks, hedge funds, and various securities markets ”“ and that it was not going to be responsible for any problems that developed.

The Fed also argued that M3 could be reconstructed from existing data if anyone cared to do so, and some economists have done just that. The result shows an astounding growth in M3 balances of 12% in the past year, double the growth in either M1 or M2, and clearly a sign that the debt process was running amok on Wall Street. No wonder the Fed wanted nothing to do with it.

Banking Then and Now

Credit is the lifeblood of any modern economy, and traditionally banks have been at the center of the credit creation process. The design of the Federal Reserve System is intended to provide some control over bank lending, and a necessary back-up to the banking system in times of crisis.

The control is done in part through periodic supervision to monitor the credit process, encourage best practices, and stamp out dangerous practices. More importantly, the Fed can increase or decrease interest rates, change the amount of deposits banks must hold at the Fed for the loans they make, and open or close the discount window that allows the Fed to extend lender-of-last-resort credit to banks in trouble. These practices are liberalized during recession, and progressively tightened as the economy expands.

The Wall Street investment banks have never been a formal part of the Fed’s system, which is open only to commercial banks. Firms like Goldman Sachs, Merrill Lynch, and Morgan Stanley cannot borrow directly from the discount window, they cannot maintain reserves at the Fed, and they have no direct access to the interbank money market in Fed Funds. Some investment banks in the past have indirectly been supported by the Fed, which has opened the discount window to commercial banks willing to lend money to an investment bank in trouble. But this is the extent of Fed support, and it is only provided if the failure of the investment bank threatens the money markets in the U.S.

So how did the investment banks become rivals to the commercial banks as credit providers? To some extent, ever since the investment banks began helping corporations obtain credit through the issuance of corporate bonds or short term commercial paper, the investment banks have had their hands in the lending business. But in the past ten years there has been an explosion of new products and new syndication processes that has allowed Wall Street to push the commercial banks out of the way when it comes to global finance. Helping this process along in the U.S. has been the quasi-central banks of Fannie Mae and Freddie Mac.

The GSEs Supplant the Fed

Fannie Mae and Freddie Mac were chartered by Congress to help the housing market in the U.S. This charter has enabled these two Government Sponsored Enterprises (GSEs) to act in the markets as if they were the government. This has allowed them to borrow at rates close to those of the U.S. Treasury, to explode their balance sheets by loading up on trillions of dollars of mortgages, and to spur the market on even more by providing their guaranty against credit loss for banks which own mortgages.

The Fed has complained to Congress about the GSEs and their central bank-like behavior, and Congress has formally stated that it is under no obligation to bail out the GSEs in a crisis. The market doesn’t believe this, and Wall Street has peddled GSE securities around the world by describing them as the equivalent of government paper.

Central banks worry constantly about creating ”œmoral hazard risk”, which occurs when commercial banks lend foolishly because they believe they can dump their losses on to the central bank. The GSEs should have also worried about this risk, but apparently did not, because from the early 1990s they either bought or guaranteed up to $6 trillion of mortgages. This kick-started the housing boom in the U.S., which got an extra boost from the Fed itself when Alan Greenspan authorized interest rates as low as 1% in 2003.

Eventually the GSEs got into serious accounting trouble trying to hedge the prepayment risk of their mortgage portfolio, using complex derivatives products from Wall Street. The GSE regulator intervened, executives at both Fannie Mae and Freddie Mac were fired, and to this day a cap exists on the amount of mortgages that can be bought or guaranteed. Fannie Mae still hasn’t been able to publish proper accounts for nearly five years.

Wall Street Creates a Debt Machine

The GSEs have had to sell trillions of dollars of securities to fund their purchases of mortgages, and Wall Street investment banks have been eager to oblige them in the issuance and distribution of these securities to investors. This ”œsecuritzation” process was in itself a credit creation mechanism that by-passed the Fed, though it served the business purposes of many commercial banks that are members of the Fed system. The more GSE securities Wall Street could sell, most recently to foreign investors like the Chinese central bank, the more mortgages that could be created. The Federal Reserve was powerless to stop this process as long as Congress either welcomed or ignored the explosion in mortgage growth occurring in the U.S. and at the GSEs, and we can postulate that someone as politically sensitive as Alan Greenspan knew enough not to stand too much in the way of this development.

The important point, though, is that securitization took mortgages and other loans off the books of the banks and into the hands of investors, many of them overseas. This did have the benefit of reducing the credit risk in the banking system, and Alan Greenspan in particular was fond of extolling the securitization process and instruments like derivatives as risk-reducing measures for banking and the economy. But while the commercial banking system had less risk, the Fed had less ability to restrain the growth of credit in the economy.

Wall Street in the past ten years has expanded its securitization process wherever it can. The mortgage-backed securities (MBS) market, which bundles thousands of individual mortgages into bonds investors can conveniently buy, exploded right along with the housing boom. You could say that the relationship between the housing boom, the government support provided by the GSEs, and the MBS market was symbiotic, each feeding off the other in a frenzy of double-digit annual growth.

But the MBS market didn’t really become the centerpiece of the mortgage business until 2004, when the GSE’s found themselves constrained from further business. Wall Street had a securitization process at hand ready to replace the GSEs, but what it didn’t have was an ability to control the credit risk of the mortgages being created. It’s not even clear Wall Street cared, or maybe the incentives of churning more and more mortgages through the system caused them to look blindly the other way. Either way, as soon as the MBS market went into high gear, credit standards collapsed. Mortgages that the GSEs would never have been able to accept now became the norm ”“ no proof of employment or income, no down payment, no principal payments required, and negative amortization all became standard features.

To sell the millions of mortgages that were now running through the system, Wall Street used derivatives products like Collateralized Loan Obligations and Collateralized Debt Obligations to slice and dice the cash flows from mortgages and sell them in tranches based on their default risks. The ratings agencies Moody’s and Standard & Poor’s modeled each of these securities transactions and invariably came up with very low default risk, based on what was known statistically about mortgage behavior. Unfortunately, nothing much was statistically known about the 2005 and 2006 mortgages being booked that had dramatically weaker credit standards, but that didn’t stop the ratings agencies from placing Aaa ratings on securities that included sub-prime mortgages in their cash flows.

When we say ”œWall Street banks” we don’t just mean the New York investment banks. The top 20 ”“ 30 commercial banks in the world morphed into investment banks in the 1990s, mostly to compete with the likes of Goldman Sachs and Merrill Lynch who were encroaching on the banks’ customer base, but also in response to pressure from the central banks who wanted the commercial banking industry to improve its risk-based capital practices. In the U.S., this merger of the two banking worlds was complete when the Glass-Steagall legal firewalls between the two industries were eliminated. This new world of overlapping functions has greatly complicated the role of the central banks when it comes to market crises.

One focal point in the current credit market meltdown is a sector of the market known as Asset-Backed Commercial Paper (ABCP). This paper is issued by legal entities called conduits or Structured Investment Vehicles (SIVs) set up by the largest banks to purchase mortgage securities, auto loans, credit card receivables and all sorts of other debt that these banks want to issue but do not want to keep on their own balance sheet. To finance these assets, the conduits issue short term commercial paper, and the investors who buy this ABCP know it is not an obligation of the bank, but only of the conduit. Theoretically, if the conduit fails the investors may lose all their investment, because they cannot turn to the bank for help.

Because of this legal independence, conduits have an array of credit protections, often including an emergency loan facility from the bank to provide liquidity if the conduit is having trouble selling its commercial paper. Investors cannot always be sure if the ABCP they are buying is going to be collateralized by mortgage assets, auto loans, etc., so in the current crisis many are assuming that sub-prime mortgages are involved and they are refusing to buy the paper. The conduits are now facing potentially dire circumstances because they survive only on the steady reissuance of their commercial paper. Many are beginning to turn to their bank sponsors to take down emergency loans from the bank. There is an estimated $1.2 trillion of ABCP currently in the market, so we are talking about multi-billions of dollars of emergency liquidity being required from the banks.

The ABCP business sprung up to help Wall Street move a growing number of mortgages from the balance sheets of the banks to the hands of investors through securitization. But this business also showed banks that the credit creation machine didn’t have to stop at mortgages, but could include other forms of retail debt. And if this could be done, why not apply the concept of securitization to corporate debt?

Why Stop Just at Mortgages?

By the 1990s the credit creation process was applied to corporate lending, particularly to the buyout business developed by private equity companies like Blackstone and Kohlberg Kravis and Roberts, which were eager to buy cash rich companies, take them private, polish them up with cost cuts, and then bring them back to the stock market a few years later at tremendous profit. To do this, these companies needed massive amounts of credit, and Wall Street converted its tried and tested securitization process to the task at hand. Securities were packaged and sold just as quickly as deals were announced, and not surprisingly, by 2007 credit standards on these transactions had deteriorated in the same way as mortgage loans had deteriorated.

The most eager buyers of all this paper were hedge funds, the secretive pools of investment capital that promised 20% to 30% annual returns, and extracted enormous fees and bonuses for their managers as compensation for such generous profits. To get these profits, however, the hedge funds had to leverage their equity, which means for $100 million of investor capital, they would often borrow $1.0 to $2.0 billion extra.

And who was there to lend to the hedge funds? Wall Street investment banks, which dropped their usual reticence to putting loans on their balance sheets, and began to bloat their assets with the hedge fund loans they couldn’t readily sell to investors.

We should not forget the accounting conventions that helped churn these transactions at an ever-quicker pace. Loans held at banks have interest income, which is the difference between what the customer pays in interest and what the bank pays on its liability funding the loan. This interest income dribbles in over the life of the loan, is relatively unexciting, but does pay the bills over time for a well-run bank.

The securitization process accounts for transactions very differently. The securities, composed of thousands of loans, are marked-to-market, which means that at day one all the projected income over the life of the security is present valued and taken completely into income. This has the great advantage for the traders of creating a big pool of revenue for their bonuses, but unfortunately no further income can be assured in the future to cover the bills. So the traders have to book more and more securities to keep covering their costs, including the sizeable bonuses to which (no surprise here) they quickly become accustomed.

The Inverted Pyramid

As you think of this entire debt creation process, involving one securitization after another, and leverage pumping up the debt volumes much higher than pure business need would require, and mark-to-market accounting pressuring traders to do ever-greater amounts of business, remember that most of it was done outside of the banking system. To be sure, the very largest banks, like Citibank, Bank of America, and JP Morgan Chase, have become like investment banks and were very active in securitizing debt just as much as the investment banks. But even they kept as little of the securities and loans on their balance sheet as possible, making room for the volume of business that was sure to come next quarter.

This credit creation process was also replicated in many other countries, and housing booms were ignited in the U.K., Australia, Canada, New Zealand, China, and elsewhere. In each case, as with the U.S., an inverted pyramid of securities, derivatives, and loans was built upon a base of underlying mortgages or other basic credit transactions, and the base was becoming progressively weaker as credit standards were undermined.

In terms of the U.S. dollar components of the process, the deposit accounts receiving all the electronic credits for the loans being made showed up in M3, which explains why the growth rate in this money supply statistic kept increasing until it reached this year’s 12% annual rate. What was critical about all this growth is that it was largely outside of the banking system, and the Fed couldn’t stop it. Worse still, the Fed had no legal responsibility for any problems that might crop up, except in the specific case of the very largest commercial banks that were involved in securitization, and in the general sense of helping ameliorate a credit crisis.

Disillusion Sets In

It has long been recognized that the banking system rests on a grand illusion. Your deposit at the bank is not really there ”“ it has been lent out to someone else. You can only retrieve your deposit if just a few other depositors want their money out at the same time; otherwise you have a run on the bank.

The entire concept of paper and electronic money is an illusion as well. The dollars issued by the Federal Reserve only have meaning if the public puts implicit trust in the government to be able to honor all legal claims made in dollars, whether they are public or private, domestic or foreign. The Federal Reserve understands this well, and guards its public image as a repository of trust more carefully than anything else it does.

It is this confidence that girds the commercial banking system, allowing the public and corporations to trust not only that deposits will be safeguarded with insurance, but that bank failures on a large scale will be avoided. This means that the credit creation process will be monitored and controlled to prevent serious systemic abuses that could damage the economy.

When a parallel credit creation process arises it lacks the governmental underpinning that supports the credit created through commercial banks. Confidence is much harder to maintain, and it is much easier to disillusion the participants in the system. This is precisely what is now happening to Wall Street’s credit creation process. The process has been overloaded with security upon security, and the transactions at the base that are supposed to support these securities are themselves riddled with credit flaws. Wall Street’s securities have been sold all around the globe, and its process has been replicated in many countries. Each of these processes are linked by mark-to-market accounting standards that require daily prices for hundreds of thousands of securities, and if one security anywhere in the world is marked down by, say 30%, to the extent this is public information (and it is usually known to the brokers who intermediate in the process), then all such securities globally must be marked down 30%.

It doesn’t matter that only one sector of the market, like sub-prime mortgages, is actually experiencing dangerous customer defaults. Once confidence is lost in one sector of this parallel credit creation process, it is lost in the entirety of the process. This is why investors around the world have been selling all types of securities, leading to panic selling of higher-quality assets just to raise cash to meet collateral requirements under margin calls. Investors intuitively understand that defaults in this system could get out of control, because no central bank has been monitoring the process for credit weaknesses.

This is also why intervention by central banks now, such as this week’s 50 basis point cut in the Federal Reserve’s discount rate, may only prove to be temporarily ameliorative. The Fed earlier in the week had said it would intervene in the markets only if a ”œcalamity” occurred, and a few days later the discount rate cut suggested that something calamitous had happened. Based on the fact that the discount window can now be accessed for 30 day loans rather than just overnight money, and that the Fed also will now accept mortgage securities as collateral, we can assume one of the calamities involved Countrywide Bank. This commercial bank is a member of the Federal Reserve System and has access to the discount window. It is owned by Countrywide Financial, the country’s largest mortgage lender, and a company which a Merrill Lynch analyst said earlier in the week was possibly heading for bankruptcy. This led to an old-fashioned run on the bank, in which depositors were beginning to line up to get their money out. Nothing instills primal fear in a central banker like a run on a bank, which brings back all sorts of images from the 1930s Depression. This discount rate cut is first and foremost designed to stop the bank run in its tracks by giving Countrywide Bank whatever cash it needs.

The second likely calamity involved the ABCP market. Many conduits are simply unable to roll over their commercial paper, and they are turning to their commercial bank sponsors for emergency liquidity. This is very serious stuff because of the potential that hundreds of billions of dollars of loans now may need to be booked by the banks themselves, in effect bringing all this off-balance-sheet business right back on to their balance sheet. This could dramatically weaken their capital ratios, and certainly will put strain on their own financing activity. Hence not only did the Fed open the discount window to these banks, it specifically said that to borrow from the Fed was no longer to be considered an embarrassment and sign of failure, but a sign of ”œstrength.” Discount window borrowing has always be shunned by the banks, and as of last week the amount borrowed was a paltry $11 million. Now it is the Fed itself that is trafficking in illusions, trying to convince the market that nothing is wrong if discount window borrowings balloon by billions of dollars.

The Fed’s action will help some of the large U.S. commercial banks that are deeply mired in the securitization process, and it may help these banks lend to investment banks facing much deeper problems. But it does not necessarily force U.S. commercial banks to make loans to investment banks, hedge funds, or other players who now may be facing bankruptcy. Also, it does nothing to change the true weakness staring everyone in the face ”“ this credit creation process has been out of control, and it has been run on deteriorating if not deplorable credit standards for years. Liquidity cannot solve these problems; only the bankruptcy courts can.

It All Comes Down to Cash

As we watch the pyramid being dismantled, as hedge funds reduce their holdings and try to pay down debt (or are forced to do so because of margin calls), as ABCP conduits discover they don’t have the ability to replace their commercial paper borrowings, and as the mark-to-market process works its inexorable damage now that prices are going down, we discover how little actual cash was in the system in the first place. The participants in this credit creation process had created their own, fatal illusion: that debt is liquidity, just like cash. ”œThe world is awash in liquidity” has been repeated so many times in recent years, but the truth is that debt is not liquidity and it certainly isn’t cash.

The demand for cash to meet margin calls, or handle investor redemptions, or replace funding that has now dried up, is so strong that pressure has been building on short term bank deposit rates, forcing central banks to inject huge amounts of liquidity into the banking system to restore these rates to levels seen just a week ago. What this tells us is that the entire parallel credit creation process has frozen up, leaving the world dependent on the traditional commercial bank/central bank credit creation process.

This traditional process is not only way too small to handle all the credit needs that Wall Street created, it has also atrophied over the years. Bank credit departments, where analysts once numbered in the hundreds at big banks, have shrunk as banks have determined they don’t want to hold on to loans anymore. Banks simply don’t have the means even to analyze the risk, because increasingly they are relying on Moody’s and Standard & Poor’s to do this for them. Unfortunately, these ratings agencies have been found wanting, and may wind up being taken over by the government before this crisis is completely cleaned up.

The global economy cannot survive for long on the traditional credit creation process, and unless Wall Street can revive confidence in its securitization process almost immediately, a global recession starting later this year is a high likelihood. Wall Street might have a chance if it could make public very soon the nature and extent of the problems with its credit creation process. But this is one of the key differences between the two processes ”“ problems in the commercial banking system are quicker to surface, and there are regulators ready to intervene. Not so with the complex, sprawling, opaque, and unmanaged Wall Street process, whose raison d’etre seemed to be to generate fat bonuses for many involved, with little thought to the systemic and economic risks being created.

We shall see what good the Fed and other regulators can do with interest rate cuts and any other interventions they can think of, but the problems are so large and unwieldy that no one should hold out much hope. The implosion of the Wall Street credit creation process is unprecedented in its depth and international scope, and the global economy will be fortunate indeed to avoid severe and prolonged damage.

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Numerian is a devoted author and poster on The Agonist, specializing in business, finance, the global economy, and politics. In real life he goes by the non-nom de plume of Garrett Glass and hides out in Oak Park, IL, where he spends time writing novels on early Christianity (and an occasional tract on God and religion). You can follow his writing career on his website,

48 CommentsLeave a comment

  • on the subject available. It provides an overview of the genesis and the features of the problem that I have not seen, except by implication in other works.

    It is true right down to the anecdote. I met a guy at a big city wedding yesterday who is in small-cap private equity, and he is losing his two major sources of credit. These sources are private funds that issue debt and make loans to private equity.

    He will be stuck managing what he has and will not be able to do any more deals.

    (The wedding guest did beat his breast.)

  • I think what your friend is describing has been occurring for over a year in the housing market. A point is reached where a freeze occurs on new activity and everyone just stays in the house they own for a lot longer than they were expecting. All the brokers, real estate agents, lawyers, construction workers and everybody else dependent on houses being sold sees their income dry up. So dependent were people on the churn that you hear all these complaints that the only houses that can be sold are those that qualify for Fannie/Freddie guidelines. Yet this is how we all lived prior to 2004.

    When you apply this freeze concept to the financial markets it is a lot more serious, because they have depended on churning the portfolio since 1990 when mark-to-market became prevalent. If no new deals are coming in, there will be no income to meet the bills down the road. Banks will wake up to the fact that interest income, not trading or fee income, is what determines survivability. I’d beat my breast too if that was what the future held.

  • It should be noted however that commercial banks outside the US have not followed the trend to that extent when it comes to the outsourcing of the holding of loans. Since the credit crunch is a global phenomenon it will be interesting to observe if international banks will be able to capitalize on this.

  • The German banks seemed to have been pressured to come up with support for IKB’s conduit. On the other hand, in Australia Macquarie seems to be the only bank mentioned with a problem.

  • Probably a case of misplaced patriotism since I am German. The stupidity to dabble with these bundled mortgage securities that close to the end game is just mind-blowing. Fortunately it looks like only a handful of banks are affected – although the heavy weight Deutsche Bank may be one of them. Have not heard anything about major British, Swiss and French banks though. Basel II requires them to be pretty conservative in their home markets so hopefully this regulation did some good. Of course some argue that Basel II was the reason that some of these German banks were suckered into purchasing these unhealthy American debt instruments in the first place. Stupid is as stupid does – really leaves me speechless.

  • Yes, thank you! A very informative entry on a subject that I’ve been quite curious about, but don’t know much about. Things seem to be happening, or perhaps just surfacing, much faster the last few weeks. If the disillusionment continues to spread, how fast do you think things will spin further out of control?

    In the past , we’ve always had Administrations that cared about things like the economy and infrastructure. This one seems to be above caring about little things like making the government work effectively. Is Countrywide just the financial equivalent of a bridge in Minnesota?

  • The banks are among the main contributors to the Republican Party, and they certainly wish the Republican Congress was still in power to protect their new bankruptcy code changes.

    Things will continue to spin out of control, only probably with stretches of nothing happening. At some point later this year or into next we will get a very sharp drop on Wall Street when there is a realization that this situation cannot be fixed by the usual central bank maneuvers. If this gets really bad, expect the markets to sense that our real problem is deflation, not inflation.

  • Thanks, Numerian, for taking the time to work this up for us.

    What’s do you see happening when the subprime meltdown kicks in Jan-Mar 08, when the bulk of the resets are scheduled? Seems like we’re only seeing the tip of the iceberg so far. In addition, many US consumers are way over-extended in other ways, e.g., credit card debt, which is technically unsecured although the recent changes in the bankruptcy law modify this. Could these converging factors (and probably others that haven’t surfaced yet) be the snowball from hell?

    That leads to another question. The past several years have seen a US economy characterized by increases (excesses) in finance rather than gains in production. That seems to be crumbling. What’s left, or is the US economy “hollowed out,” as some have been warning?

  • So far we have had a significant meltdown in the credit markets based only on problems in sub-prime and Alt-A mortgages. Given the facts you’ve cited – over-extended consumers, bankruptcy law changes – it seems likely that these problems are going to spread to the economy and drag down millions of middle-class Americans into bankruptcy.

    As to your second point, the largest component of corporate earnings in the S&P 500 comes from the financial sector – about 22% of total earnings compared to 7% in 1990. This is a record percentage, matched closely by the tech sector in 2000. Usually, when any one sector comes to dominate the S&P 500, it signifies a peak for the market and certainly for the sector involved. Leading the move down in this current market is the financial sector, so this should not be surprising.

    If the financial sector is weakening, given its position of dominance in the economy, it suggests the economy may be heading into a recession. As you say, the rest of the economy has been hollowed out, and will offer little support if the financial industry heads south.

  • the singularly striking aspect of it all has been the transparent absence of real wealth creation for economies in general, notably a lack of productive activity in meaningful job creation. Deregulated capital has always been about simply moving money round the world, seeking short-term gains to reward an increasingly smaller proportion of the general population with an increasingly larger slice of national income. Big bonuses on Wall Street and The City for chancers and wide-boys, egregiously huge rake-offs – sorry, “dividends” – for private-equity principals, untenable and unjustified “fees” paid out to hedge-fund managers…profits made on highly leveraged bets – one is tempted to think “one-way” bets, though it does appear that several if not dozens of hedge-funds will in fact go to the wall – at the expense of stability of national economies. Much of the volatility in equity markets the past month can be laid to huge positions taken by hedge-funds that need liquidity transfusions TODAY, thus the “unwinding” clusterfuck now roiling bourses across the globe. And much of the early support for promotion and sustaining of this cancer can be laid at the foot of Greenspan and his acolytes, who reckoned that “bubbles” were in fact vehicles for enrichment of the few, with “trickle-down” benefits for the many, and whose bursting was simply the actions of an unfettered market self-correcting…just inject some more cheap money into the system, and let the games begin anew. The question, of course, whether this latest crisis will be ’98-’99 revisited, or something in fact much more profound and enduring.

    “les Etats-unis, c’est le seul pays à être passé de la préhistoire à la décadence sans jamais connaitre la civilisation…”…Georges Clemenceau

  • The damage that LTCM could have caused was contained because the Fed organized an orderly unwind of its trades, virtually all of which were with major commercial and investment banks. Nor were there many of the complex derivatives deals seen today (CDOs and CLOs). LTCM was a cakewalk compared with trying to sort out some of the securities messes today.

    The Asian currency crisis and the Russian bond problem were isolated in those areas. Some big banks lost money but none was threatened with survival.

    In today’s crisis we have already had the absolute failure of two hedge funds at Bear Stearns, causing over $1.0 billion in losses. Over 50 mortgage brokers in the U.S. have gone out of business in the past year. Some of the names that pop up with problems seem to quietly file for bankruptcy and disappear. Sentinel made its bankruptcy filing this Friday afternoon but I’ve seen nothing in the press, given all the market activity on Friday which took over the headlines.

    Things are happening so fast that no one is getting a chance to catch their breath and comprehend the significant damage already done. Even if no more bankruptcies occur, what the market must deal with is the likely permanent shut down of several market segments, like CDOs and CLOs and ABCP with mortgage backing. Talent will drift away from these industries rather than baby sit a declining portfolio for five years. Of course, where this talent goes for their next job is really open to question, especially if the market continues to deteriorate.

  • And to all the excellent comments afterward. This is why the Agonist needs to exist, one of my favorite sites. Even if most signposts here are pointing to “Hell”. At least I know to bring some extra water 😉

  • Spiegel Online – Just last week, German banks reassured the world that they weren’t overly exposed to the American sub-prime crisis. The weekend bailout of Sachsen LB, though, brings Germany’s Achilles’ heel into the spotlight.

    As recently as last week, German banks sought to convince investors that they were not overly exposed to the suddenly wobbly US mortgage market. But as the weekend bailout of Sachsen LB demonstrates — coming just two weeks after a similar bailout of IKB Deutsche Industriebank AG — the reassurance wasn’t completely accurate.

    On Friday evening, Sachsen LB announced that the German association of savings banks was making €17.3 billion ($23.3 billion) available to the Saxony state bank to cover an affiliate that was suddenly unable to provide the credit it had pledged. The bank denied a weekend SPIEGEL report that losses of €500 million loomed due to direct involvement in sub-prime mortgages. But the bailout is raising new questions about the health of Germany’s banking system and its ability to weather the kind of precipitous drop in investor confidence kicked off by the collapse of the sub-prime market (more…) in the US.

    The problem, analysts say, stems from the tendency of some German banks to issue lots of short-term debt — exactly the kind of debt investors are currently keeping at arm’s length. The quick-turnaround loans, known in the industry as “commercial paper,” are often used to buy securities, which, in the case of Sachsen LB, were backed by US mortgages.

    Even worse, those asset-backed commercial papers (ABCPs) are often issued by affiliates which make no appearance on the mother ship’s balance sheet. It was just such an affiliate, known as a “conduit,” which sent Sachsen LB to the brink. Called Ormond Quay and based in Dublin, Ireland, the conduit ran into liquidity problems as investors began shying away from ABCPs, leaving Sachsen LB in a bind.

    more at link

    “George Washington did not cross the Delaware for Capitalism,” Shmuley Boteach

  • What’s interesting in the German case is that the conduit’s needs are gargantuan. One line of credit from the sponsor bank would never be sufficient to cover a €17.3 billion shortfall. No wonder a consortium of banks is necessary to raise all this funding. The same things seems to have happened in Canada.

    These state banks have the supposed advantage of being supported by their government. I wonder what would happen if they really had to turn to the state for help?

    And what about those conduits in the U.S. or Japan that don’t have clear government support?

  • . . . the Target Store down the street. Everyone who shops there takes the shopping carts off the property, and wanders off down the streets so they don’t have to carry nothin, and then they just leave the carts wherever and they end up turned over and laying around all over the place, in streets, down boulevards, in bushes.

    And. . . Target gets blamed for it, and they have to pay to get it all cleaned up. And everyone complains not about the idiots who take the carts all over the place and dump em in the bushes, but the Target store who provides the carts to customers in their store.

    Blame everyone but the idiots in the store, er bank.

  • The Targets (and other grocery stores, too) here have magnetic (I think) wheel locks that engage when the carts leave their parking lot, kind of like a dog’s invisible fence. I think I’ve seen them in other cities, too.

  • what do we do about it?

    1. Immediately

    2. Long term.

    Also, who in Congress, if anyone, has a clue and special interests pushing him/her in the right direction? (Hey, occasionally it happens. Big banks who wanted to be players internationally helped push the Fed through Congress way back when.)

  • Not too much can be done immediately because it is not clear who has a problem and how big it is. But let’s look at some options.

    1. Asset-backed commercial paper is no longer trading in the market. If someone had a magic wand that said “this paper is tainted by mortgage risk but this other paper is not”, that still wouldn’t solve the problem. Other ABCP is now tainted because so many structured vehicles are dumping automobile loans, credit card receivables and other securities where default risk hasn’t changed, but the value goes down nonetheless since it’s being dumped so aggressively to raise cash to cover the mortgage paper that can’t be sold.

    2. Suppose the SIVs are able to convert the paper from short term to long term. Assuming they get the funding long term, they still have to cut down sharply on their business volume because their short term funding, if available, will be much more limited. This takes about $1.0 trillion of transaction flow out of the global economy – not overwhelming, but certainly noticeable. It means banks will be doing less credit card, automobile and other financing.

    3. For 2. to happen, the banks will have to come up with the funding, and their central banks will have to provide it and ignore the distortions this will cause bank balance sheet ratios. A significant question will arise for the central banks, as to whether they neutralize all this extra liquidity from the money supply, by removing it in some other way.

    4. None of this takes into account any further worsening of the default rates in the mortgage business, or any spread of the default problem to other financial sectors like corporate debt. A lot depends on whether the economy can sustain all this cessation of business, loss of liquidity, write-downs of assets, and defaults of conduits and some hedge funds. I have my doubts; what we are seeing already would sink a normal economy, much less one dealing with oil price shocks and huge trade imbalances.

    5. These problems can play out anywhere from 2 to the next 5 years.

    6. Looking long term, a lot depends on the severity of the recession that ensues. Chances are it will be at least as severe as the 73-74 recession when we had similar circumstances occur. If so, here are some possible solutions:

    a. Somehow the Wall Street debt machine has to be backed by the government. This means in the U.S. that the investment banks will be brought in under Fed supervision and given similar status to commercial banks. This will allow the Fed to regulate the securitization process, and central banks in other major countries will need the same authority. The Fed will also be given broad powers to regulate parts of the mortgage industry in the U.S.. The GSEs will remain untouched, for political reasons, but their ability to inject moral hazard risk into the economy needs to be controlled.

    b. Central banks will develop powers to purchase securities, even complex derivatives, in order to provide liquidity in a crisis.

    c. Much more transparency will be needed for ABCP. The financial industry will be forced to set up a global clearing house with daily pricing, and members will provide mutual guarantees over the total risk.

    d. Moody’s, Standard & Poor’s, and Fitch will be lucky if they are not nationalized. More likely, an international supervisory board, similar to the one used for accounting standards, will be set up with oversight authority for the ratings process.

    e. The Fed will be forced to accept ECB standards when it comes to asset bubbles – i.e., central banks will agree it is their responsibility to monitor and measure asset price increases, and take any undue price pressures into account when setting interest rates.

    f. The dollar will continue to fade as the reserve currency of the world. Oil will probably be priced to the euro or to a basket of currencies, giving OPEC its own petro-currency.

    g. China’s recession will be much worse than any other country and considerable social upheaval there can be expected. It’s 50/50 whether China’s current embrace of capitalism will continue.

  • The practice of off-balance-sheet entities must cease. Enron’s biggest and last OBS was “only” $1bil. I was (very) peripherally involved in the “broadband trading” section that created this OBS, and remember scratching my head about our reported revenue.

    A $23bil shortfall is madness. European public companies have been subject to more lax disclosure, less so recently. If one is open, five more are on the way.

    In the 90’s Daimler Benz opened up their books to disclose that they had made and blown a billion during the 80’s. Made it from cars & trucks, blew it on various large projects that died.

    Forget it, Jake – it’s AmnesiaTown

  • TORONTO, Aug. 20 (UPI)

    FrontierAlt Oasis Funds Management said Monday it launched a Canadian income fund based on Islamic investment principles.

    The FrontierAlt Oasis Global Income Fund will focus on Shariah-compliant companies within the Dow Jones Islamic Market Index “that have demonstrated consistency in rewarding their shareholders with strong dividend payments,” the Toronto financial services company said.

    The fund also will invest in sukuk — Islamic bonds that do not pay interest, which is not permitted by Islamic investing principles. Instead, the bonds provide income from underlying assets or services.

    “We believe this fund is an excellent income alternative for Muslim investors and provides an opportunity for all Canadian investors to participate in this growing investment category,” FrontierAlt Oasis President and Chief Executive Officer Asif Khan said in a statement.

    Islamic investment principles preclude investments in securities of companies dealing in certain products or services and operating with high financial ratios of liquid assets, debt or interest income, FrontierAlt said. These principles also require purification of income streams for purging any prohibited elements, the company said.

    “Our lives begin to end the day we become silent about things that matter” – Martin Luther King Jr.

  • I think you’re right; that should be added to the list and will probably involve a whole chapter in whatever the next Sarbanes-Oxley bill will look like bringing reform to the markets. Theoretically, you would not need to do this if the Fed is in charge and supervising the securitization process, but I guess politics will still require that something be done about these vehicles. One of the reasons I hesitate to say outlaw them altogether is we are so far beyond the days when the world could have all this risk sitting on bank balance sheets.

  • Think of all the derivatives bashing we will be hearing. But the core of the problem is the unregulated securitization process, including the use of bank conduits. The derivative instruments themselves get too opaque, but the real darkness is in the way in which this stuff is packaged and peddled.

  • Although I understand why a – f are on your list I’m not sure why you include g and, more importantly, why you think that will be the outcome.

    China, although it will be hurt, seems to have both reserve demand, both internally and in emerging markets, and the central planning capability to redirect resources.

    I also do not necessarily see the prospect of social upheaval. The Chinese government seems utterly dedicated to development and protection of its cities. It is unrest in cities that topples or drastically changes countries. Unrest in the countryside can generally be contained and suppressed.

  • The first risk for China is that it has built its manufacturing base on shaky debt. The loans made by state banks are probably 20% impaired, though some estimates come out much higher. Banks can’t easily survive with non-performers in excess of even 10%, so a government bailout on a massive scale will be necessary. China’s reserves of $1.3 trillion need to be significantly discounted for this essential bailout.

    Second, the investments that have been made have been as unwise as in the U.S., chiefly property extravaganzas. Manufacturing investments that are solid are those that team up with foreign companies for technology, but in one industry after another there is enormous redundancy that will hurt the economy in a recession.

    Third, China’s principal customer has been the U.S. consumer. No other country has been willing to go into such debt to buy China’s products. This is the classic case of relying too heavily on one customer, and worse still, financing that customer’s purchases.

    Fourth, there is a vast underground lending mechanism that supplements the state banks, and that has no state backing. Rather like the securitization market in the West. When it implodes it will be very ugly, and this may be the cause of social unrest.

    China already has an estimated 10,000 social “disturbances” (i.e. riots) each year. What happens when the economy goes in reverse?

  • Which, I guess, brings me back to my first question. Why did you include the consequences in China on your list without doing the same for Russia and the other, Mideast, petro-economies, Europe and Japan? Do you think that there will be a particularly consequential feed-back loop between the sort of events you anticipate for China and us while the others would not be so consequential? What if China manages its crisis well and has relatively little disruption?

    I ask because I have been so impressed with all of the rest of your analysis, but am a little confused by your read on China. I need to add this one remaining comment. As I continue to read Jane Jacobs (many profound thanks to all of you) and as I have travelled fairly extensively in China the last five years I see a rather remarkable correllation with what China has been attempting since Deng began the great urbanizing experiment when he opened up Guangzhou and what Ms. Jacobs teaches.

  • Oil prices will probably fall below $50 in a global recession, and Russia’s elaborate plans to rebuild themselves as a superpower will prove to be too expensive when the windfall oil revenue dries up.

    The reason I specifically cited China is because they are tied intrinsically more than any other country to the U.S. economy. You might say the symbiotic relationship of the U.S. as primary buyer and China as primary manufacturer/seller has driven the global economy. This was certainly true from 2003 – 2005, and less so now with India, Russia and other emerging markets proving to be their own engines of growth.

    There are some other reasons to single out China. China is playing the role that the U.S. played in the 1920s, when it was the principal global manufacturer, and financed its sales to European customers. The U.S. economy began to weaken when credit problems in Austria surfaced and spread elsewhere in Europe. The U.S. fell into depression perhaps for other reasons, but it didn’t help that its main customers could no longer obtain the debt necessary to buy U.S. goods.

    It also seems unusual that China’s growth as a capitalist power will be at 10-12% annual rates without severe recessions intervening. No other emerging market has been able to avoid that price, especially one with money supply growing at 18% p.a. and growth financed by a corrupt banking system.

    I would suggest another longer term concern. Third world economic development since the 1950s had always been described as the third world catching up to the West. What’s happened since the 1990s is that this catch-up scenario seems elusive if not wrong. In fact, China and India seem to be growing at the expense of the West. If Western living standards are going to shrink over time and meet up in the middle somewhere with Chinese living standards, then our current model of the U.S. as buyer of last resort of everybody else’s exports simply won’t work. Especially when it comes to the U.S. buying from China. This model has to collapse economically if the politicians don’t take it apart first, so China is on my list of long term concerns because of how this will play out.

  • The Bonddad Blog

    The Problem Spreads And The Fed Can’t Help

    From Bloomberg:

    The $1.1 trillion market for commercial paper used to buy assets from mortgages to car loans has seized up just as more than half of that amount comes due in the next 90 days, according to the Federal Reserve. Unless they find new buyers, hundreds of hedge funds and home-loan companies will be forced to sell $75 billion of debt backed by mortgages, according to Zurich-based UBS AG, Europe’s largest bank.

    Those sales would drive down prices in a market where investors have already lost $44 billion, based on Merrill Lynch & Co.’s broadest index of floating-rate securities backed by home-equity loans. That may hurt the 38.4 million individual and institutional investors in money market funds, the biggest owners of commercial paper.

    “We’re dumping all this collateral into the market and it becomes a death spiral for the assets,” said Brian McManus, head of collateralized debt obligation research at Charlotte, North Carolina-based Wachovia Corp., the fourth-biggest U.S. bank by assets. CDOs contain pools of mortgage securities that have been repackaged and sliced into pieces.

    This is the big reason the Fed shouldn’t lower rates. Just because banks have more money to lend doesn’t mean they will be able to find borrowers or steer those borrowers to a certain type of asset. The bottom line is investors and borrowers aren’t touching anything right now. No matter how much cash they have, they won’t go near anything except T-Bills:


  • Exactly. 1.2 billion people can mercantaly industrialize on the backs of 300 million – especially since a pile of other people are trying it at the same time.

    I would add the oilarchies to this, by the way – even though the US doesn’t physically get most of its oil from the ME, the relationship is really a 3 way one – the oilarchies money is very hot and able to be moved around easily and that gives them a hell of a lot of leverage. And they do have huge amounts invested in the US. Likewise, money, as Stirling would say, is what people will take for oil. That does matter.

  • Several responses.

    First I agree that China is likely to face recessions. However, I think that the analogy with the U.S. in the 20’s and 30’s is not a good one. I think that China is far more prepared to deal with its role as the major producing and more importantly eventually (shorter rather than longer term) the major consuming nation than the U.S. was at that time. It seems to me that they are far more like the U.S. in the post WWII period. As I added to my post above there seems to be an extraordinary correlation between the teachings of Jane Jacobs and Chinese policy since Deng’s Guangzhou experiment that suggests that they have a rational view of their future rather than a simply ideological view.

    As to your last observation I’m not sure why this is happening other than because of the short-sightedness of our politicians. As I have said before it seems to me that Kyoto was as important as a sort of taxing mechanism by which we would force ourselves to develop a new energy infrastructure while the Chinese and Indians etc. played catch up using old energy, as it was an environmental exercise. It was our opportunity to actively grab the economic initiative.

    I agree that the model using us as buyer of last resort is on its last legs. We have consistently squandered our wealth (productive capacity) and replaced it with the appearance of wealth denominated in debt. I don’t see a happy end to this if happy is defined as our maintaining our preeminent economic position in the world.

  • That the problems are spreading to standard commercial paper for corporations with poor credit ratings. Unfortunately, about 70% of all corporate bonds from U.S. companies are now rated as junk debt, so this could envelop quite a lot of commercial paper.

  • The U.S. was thoroughly industrialized by 1940, especially after the war. China is still 80% agricultural, like the U.S. was in the 1920s. That’s why I made that analogy. Also, I think the Chinese government’s control over society is rather weak and that capitalism has taken off in an almost pure laissez-faire environment. At least that’s what I’ve heard from Chinese government officials. They also seem to worry about “keeping a lid” on brewing social tension.

  • I feel totally out of my element here but I would like to ask a couple of questions at the risk of revealing my ignorance:
    1. How does the Central Banks intervention help the situation? Seems that means they are buying nothing more than time so that some investors have a chance to divest from troubled funds but at some point somebody is left holding the bag. Is that right?
    2. If the fed is making money available to commercial banks to loan to investment banks then doesn’t that risk spreading the misery to commercial banks?

  • 1. In the short term the hope of the central banks is to calm the market and ease congestion. When Eurodollar rates shot up to 6% the injection of money by the ECB pushed rates back to their desired level; same with the Fed when Fed Funds moved beyond 5.25%. So this allowed the banks to meet customer demand for short term money. None of this changes the amount of any market losses investors or the banks may have from defaults; as you suggest, liquidity just buys time. Without the liquidity, however, there could be more panic selling of assets that pushes values down and causes more mark to market losses.

    2. In the long term, the central banks run the risk of rewarding risky behavior, of which there has been plenty. Your point is a good one. If a commercial bank uses the liquidity to lend to an investment bank, any default by the investment bank is borne by the commercial bank and cannot be covered by the central bank. This is why just adding liquidity doesn’t fix insolvency problems; banks still have the responsibility to protect their shareholders by not making stupid loans.

  • There is a role for determined amateurs in the looming financial crisis.

    Believe it or not, your post is too long for our country’s political leaders. WH and congressional memos have to be less than two pages. What gets said to the public has to be boiled down to two sentences.

    The irony of the situation will be, as usual, that special interests are too entrenched to move unless there is a crisis. Once there is a crisis, pols will be flailing around looking for an immediate silver bullet, and wondering where the hell all the smart people have gone.

    So no action, no action, no action, desperate to do the right drastic thing immediately.

    Ideally, there is some public spirited group of wizards in the wings that pops out with a ready-made solution. Occasionally, something like that happens in areas where there are established special interest lobbies. (environment, for example) But I am not sure that there is a public interest group for central bank issues. A few community lending types, but nothing broad based that I know about.

    So the lobbies are likely to be central bankers themselves. But that has to be a quiet lobbying.

    Nothing will really happen unless there is publicity that will give pols confidence, and drum up a modicum of public support. I do not have a lot of confidence in the popular media, business or otherwise.

    So someone(s) with common sense can have an impact, if they plug into the debate.

    The first step has to be to survey the way that the issues have been presented in the past few years on the Hill. Because that will be the existing frame of reference. To the extent that the discussion has been distorted (in terms of the real problem), that must be identified and documented.

    The second step is to streamline the points. Pick the most important. Target a couple of things. Start a drumbeat.

    The easiest thing on your list is to regulate the ratings agencies. There is a model for that (regulation of accountants), and the talking point is easy for the public to understand. (“Dumb, sloppy rating agencies caused problems. Punish. Correct.”)

    I guess the most important one on the list was to get the investment bank activities subject to the Fed.

    That one will be really tricky because it involves Congressional committee jurisdiction. Generally, securities committee will regulate investment banks; banking committee will regulate commercial banks. Turf is hard to overcome.

    Careful thought about an actual bill will probably be necessary. An example (that worked) from abroad would help.

    As for transparency in the system, requiring disclosure by hedge funds will probably be popular and easy to understand. But I wonder if that kind or reform would be enough.

    Like the 3rd world debt crisis of 30 years ago, managers become wealthy geniuses taking on risk, and do not become dumb asses who threaten the world financial system until years later, after they have moved on.

    Matching current incentives with longterm consequences is a challenge.

    And there is no lobby single-mindedly pursuing it.

    But if a crisis comes, for a few minutes, the pols will want to know what should be done.

  • for someone who has a big ole chunk in bank stocks intended for long term holding?
    I’m thinking take the capital gains hit now, and hold the remainder in cash or cash equivalents like gold or oil until things even out over the next 5 years. It’s that talk of deflation that either worries me or excites me, I can’t tell. I’m less than an amatuer who has zero faith in my broker, but trusts you guys a lot. Or can I easily hedge against a big drop in bank stock prices w/o getting too complicated and losing my shirt?

    sorry not to keep it to policy prescriptions, but I’m trying to think about retirement, if possible, in 15-20 years.

  • Ultimately you need a broker or adviser you can trust and meet with face to face. No one on the internet really knows your financial situation well enough to give sound advice. I can only tell you what I have done, which is sell my bank stocks because the technical and fundamental picture for financials looks pretty bleak over the next five years. Also, I am not confident that the capital gains tax rate in the U.S. will remain as low as 15% over the next five years, so combined first and foremost with a view of the sector, this was a second argument in favor of taking a capital gain now. The U.S. will be increasingly desperate for federal revenue and a Democratic Congress and President, if that seems likely, will want to restore the capital gains rate to its previous level.

  • Especially for anyone who works in the White House, where policy papers are restricted to two pages. Congressmen, of course, are too busy to read lengthy pieces.

    How much change can be accomplished depends on the damage to the global economy. If we suffer through a severe recession lasting two years or longer, there may be political will for major change. At that point, the policy objective should be fundamental reform of the securitization process. This requires countries like the U.S. to clean up the commercial/investment bank dichotomy, place it under one regulator, and bring securitization activites under that regulator.

    A second initiative would be broader and that would include regulation of hedge funds, private equity, and other buccaneers. This initiative would probably only be possible as a reform necessitated by severe economic dislocation, but arguably such dislocation would discourage a generation of people from making the same mistakes anyway (after a generation goes by, the new crowd unfortunately will repeat these mistakes).

    An easier initiative is the one you mentioned, putting the ratings agencies under a regulatory body.

    With any of these efforts, there has to be extensive global cooperation and agreement. At least for the central banks the BIS offers a venue for this purpose. IOSCO might have to step up to involve the investment banks in this.

    As you might imagine, I’m altogether gloomy and doomy about prospects for avoiding a severe recession, so I agree with you and think Congressional staff and others ought to start thinking about the right policy responses once the damage is known.

  • And I have to agree in a general sense that higher taxes can stifle investment. But when it comes to the stock market, the capital gains rate should be a secondary or tertiary consideration for investors. Most individuals sock away money into their 401k for the long term, automatically without any concern for the tax rate. Short term traders resign themselves to paying at ordinary income tax rates.

    The only people who really, really care are the private equity and hedge fund billionaires who can escape hundreds of millions of dollars of taxes by applying the capital gains rate, which is clearly allowed by regulations but is just one of those non-defensible and stupid tax give-aways. If the politicians ever had to get serious about raising revenue, this loophole would be closed tout de suite.

  • it’s a tough call as it’s a significant hit on cap gains, and BAC has been pretty solid these past @ 17 yrs, and there’s some fool out there today touting it, which really makes me think it’s time to go. But after today’s news of borrowing from the Fed, it’ll probably tank tomorrow anyhow.
    Thanks for your essay and help tho, your analysis seems pretty darn cogent to me .

  • that is why I urge the inspired amateurs to apply themselves

    if real economic collapse comes, the world will have started on a political whirlwind that won’t be some rational response to the real problem. It will be an emotional response to the most successful demogogue

    need to make smart popular earlier then that if possible

    don’t wait for the Congressional staff to come up with ideas. Most are nitwits, and very, very few want anything to do with an idea different from the pack

    that is why research on what the Fed bureaucrats and SEC bureaucrats are arguing about, and in what terms, is important. That must be the hook where an inspired amateur applies himself/herself to try to shift debate. Maybe with the noisemaking ability of Stirling or Ian, hoping some financial press will report the drumbeat

    normally this stuff is an extreme longshot, but as I wrote before, there will be a moment when pols will be desperate to hear a sensible message

    the key is to be ready at that moment

    always my hope for this site

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