When I was a child my favourite cartoon program was the Looney Tunes. Bugs was my favourite, but in constant play were the Roadrunner cartoons, in which the starving (and very clever) Wile. E. Coyote would set out to get himself supper by catching the roadrunner. Unlucky Wile never managed to succeed, but in trying he inevitably wound up blowing himself up, getting hit by large objects, or falling to his death.
The current economic and market situation reminds me of how Wile would die from falling. On occasion he’d race off a huge cliff (apparently he always chased the roadrunner right next to the Grand Canyon). He’d run off the cliff in a straight horizontal line, as if there was still ground under his feet, and then come to a stop in mid air. He’d look around, then he’d look down. Seeing the mile of dead air beneath him, he’d gulp and immediately plummet to the ground, where he’d wind up as a pancake.
In the world of cartoon physics, the law of gravity didn’t take effect until you realized you’d been breaking it. Once you did, whoosh!
The US economy and US markets, indeed the world economy and markets, have been operating like Wile. E. Coyote running off a cliff. By my estimate we’ve been off the cliff since at least 2004. Some would put the moment a couple years back from that, or maybe a year forward. But for years many of us have been looking at the US the way a spectator might look at a coyote who performed in the real world what Wile did in a cartoon, scratching our heads and wondering ”œWhat the heck is keeping him up there?”
A large part, but not the only part, of what’s been keeping the economy up there, instead of down in a ditch, is the same thing that keeps Wile up. As long as no one believes the US economy is massively overextended, that collaterlized debt instruments were properly valued, that derivatives based profits and valuations weren’t illusionary, they were willing to keep lending the US and Wall Street money and buying their pieces of paper. And as long as the money kept flowing, consumers could keep spending, brokers could keep selling collateralized debt obligations of various kinds, and everything was great ”“- especially if you were one of those getting multi-million dollar bonuses for profits on paper that are likely to turn out to have never existed.
More After the Jump
It all started coming apart with the subprime mortgage crisis. It should be emphasized that problems extend far, far beyond subprime, but it’s there that they first showed up, where they first became undeniable. It’s then that Wile, scanning the horizon, though to himself, ”œGee, I don’t see any ground. Maybe I should look down.” As people realized there was no “there,” there; that many of these mortgage backed securities were worth cents on the dollar, they stopped being willing to buy them. The defaults started occurring and as people kept looking more and more they began to be forced to actually consider ”œHow much is this worth?” And they didn’t stop at subprime mortgages.
Now the reason this mattered is that most Wall Street firms (and many banks) have a ton of this paper, and they are also heavily leveraged with loans. Those loans are loaned against the value of their portfolios. So when other firms and various banks started realizing the paper was worthless they stopped wanting to continue to extend loans. When the loans came due (and most loans these days are short term, from days to months) they didn’t just roll them over.
Without the loans firms began to face the possibility that to meet their obligations, to pay back the non-rolled-over loans, they might have to actually come up with cash. Which means they might actually have to sell some of this paper. And if they sold it, they’d know what it was worth. And if they knew what it was worth, they’d have to mark down all of it in their portfolio And if it’s really worth cents on the dollar, well that could wipe out billions. In fact, it could wipe out the entire capital of firms.
Which is where we come to Level 2 and 3 Assets:
There’s a mystery on Wall Street. Merrill Lynch last week wrote off $8.4 billion in its subprime mortgage business, a figure revised up from $4.9 billion, yet Goldman Sachs reported an excellent quarter and didn’t feel the need for any write-offs. The real secret of the difference is likely to be in the details of their accounting, and in particular in the murky world, shortly to be revealed, of their ”œLevel 3” asset portfolios….
…From November 15, we will have a new tool for figuring out how much toxic waste is in investment banks’ balance sheets. The new accounting rule SFAS157 requires banks to divide their tradeable assets into three ”œlevels” according to how easy it is to get a market price for them. Level 1 assets have quoted prices in active markets. At the other extreme Level 3 assets have only unobservable inputs to measure value and are thus valued by reference to the banks’ own models.
Goldman Sachs has disclosed its Level 3 assets, two quarters before it would be compelled to do so in the period ending February 29, 2008. Their total was $72 billion, which at first sight looks reasonable because it is only 8% of total assets. However the problem becomes more serious when you realize that $72 billion is twice Goldman’s capital of $36 billion. In an extreme situation therefore, Goldman’s entire existence rests on the value of its Level 3 assets.
The same presumably applies to other major investment banks ”“ since they employ traders and risk managers with similar educations, operating in a similar culture, they probably have Level 3 assets of around twice capital….
…There has been no rush to disclose Level 3 assets in advance of the first quarter in which it becomes compulsory, probably that ending in February or March 2008. Figures that have been disclosed show Lehman with $22 billion in Level 3 assets, 100% of capital, Bear Stearns with $20 billion, 155% of capital and J.P. Morgan Chase with about $60 billion, 50% of capital. However those figures are almost certainly low; the border between Level 2 and Level 3 is a fuzzy one and it is unquestionably in the interest of banks to classify as many of their assets as possible as Level 2, where analysts won’t worry about them, rather than Level 3, where analyst concern is likely.
The reason analysts should worry is that not only are Level 3 assets subject to eccentric valuation by the institution holding them, but the ability to write up their value in good times and get paid bonuses based on their capital uplift brings a temptation that few on Wall Street appear capable of resisting. Both Goldman Sachs and Merrill Lynch are reported to have made profits of more than $1 billion on their holdings of Level 3 assets in the first half of 2007, for example, profits on which bonuses will no doubt be paid at the end of their fiscal years…
…Defenders of Goldman Sachs and the rest of Wall Street will insist that less than 27% of their level 3 assets are represented by subprime mortgages yet that is hardly the point. Subprime mortgages, estimated to cause losses of $400-500 billion to the market as a whole, though only a fraction of that to Wall Street, have been only the first of the Level 3 asset disasters to surface. There is huge potential for further losses among assets whose value has never been solidly based.
The author, Martin Hutchinson, then goes on to detail a number of very risky, and likely overvalued asset classes. But let’s step back a bit and examine the levels of assets:
Level 1 means the values come from quoted prices in active markets. The balance-sheet changes then pass through the income statement each quarter as gains or losses. Call this mark-to-market.
Level 2 values are measured using “observable inputs,” such as recent transaction prices for similar items, where market quotes aren’t available. Call this mark-to-model.
Then there’s Level 3. Under Statement 157, this means fair value is measured using “unobservable inputs.” While companies can’t actually see the changes in the fair values of their assets and liabilities, they’re allowed to book them through earnings anyway, based on their own subjective assumptions. Call this mark-to-make-believe.
For years now, much, and in some cases most of the capital of most Wall Street firms and many banks has been in assets that are either ”œmark to model” or ”œmark to make-believe”. Which is to say that the assets were traded so thinly that there was no market price to check them against, or that such market prices as existed were either very rare, and/or were sales between firms with similar expectations of what such assets might be worth.
But then there’s this thing called the ”œreal world” which dared to intervene. Housing sales slowed. Prices began to drop. Jumper mortgages where you start with a low rate then jump to a higher variable rate started to reset. Those unfortunate enough to take Greenspan’s advice and take variable rate mortgages also suffered from them.
In short, defaults and the prospect of defaults began to go through the roof. The collateralized debt obligations (CDOs) stopped performing, or people realized that there was a good chance that they soon would. Because at the end of the day a CDO is supposed to supply its owner with regular chunks of money. If it doesn’t, it’s not worth squat, and no one can pretend it is. It’s just a bad loan.
Now if the problem here was just ”œsubprime mortgages,” Wall Street would take a lickin’ and keep on tickin’. But as Hutchinson points out there’s a ton of bad paper out there: securitized credit card loans, mortgages other than subprime, asset-backed commercial paper and more. The list goes on and on.
Wall Street and America’s banks made a ton of money because the people who decided how much their assets were worth were the same people who owned the assets. And since their bonuses were based on how much those assets were worth, let’s just say those assets were worth a lot. It takes a lot of ”œprofit” to justify bonuses equal to the raises of 80 million Americans, after all.
Bernanke and the Fed are aware there’s a problem, and their easing of interest rates and other actions like forcing loans on the banks have been an attempt to deal with the problem by providing ”œliquidity”. But here’s the problem: you can give the banks money, or lend it to them, but you have a hard time making them buy huge steaming piles of crap. This isn’t the Long Term Capital fiasco where some trades went bad but there was good reason to believe that if you held onto the position and unwound it you might make money. The underlying instruments are probably crap and you will never make your money back if you buy them at face (or that’s the fear, and it’s well founded). Nor is it nearly as small as Long Term Capital fiasco was; the amounts of money involved today are magnitudes larger. So the banks, while making ”œgood citizen” noises, are mostly not willing to take that money and bail out those of their colleagues and competitors who are holding onto reams of worthless paper (the membership of which includes some big banks as well, including Citigroup).
Because this issue extends beyond Wall Street and into banks, most of whom were eager to get in on the easy and big money they saw securities firms and hedge funds earning, the consequences are going to be very, very real for ordinary people. When the banks have to take large write-downs the amount of money they will have available to lend to businesses and possibly even to consumers will also decline. Bernanke may make interest rates low, but if this cascade continues, and there’s no reason to believe it won’t, there simply won’t be the money to lend. (As an aside, this is exactly the reason why Great Depression lawmakers forbade banks to get involved in securities businesses. Removing those laws set the stage for what is happening.)
Likewise, and worse, foreigners watching the debacle are becoming increasingly unwilling to lend the US more money. Since the US requires a huge inflow of money every day to continue operating and for its consumers to continue spending, this is a potentially destabilizing situation. It is, of course, possible for foreign banks to step in, and indeed, over the last seven years foreign currency markets have been dominated by the actions of central banks, especially those of Japan and China. But China, in particular, is experiencing large rises in wages. Inflation is already much higher than the official figure and with rising wages will become higher still. Every dollar the Chinese have bought had to be bought, in essence, by printing Yuan. Those Yuan, as people cash out of dollars, are coming back into China and pumping inflation even further.
Which is to say, the cost for China of continuing to lend the US money by propping up the US dollar may soon exceed the benefits to them of doing so. It is true that if China stops propping up the US dollar and the US consumer then US demand for Chinese good will collapse, but significant goods inflation in Chinese goods from domestic Chinese inflation, plus reduced US spending as the home-loan ATM comes to an end in the US because the housing bubble has ended and Americans just can’t borrow any more mean that the US consumer is about tapped out anyway. It’s been a long run, but it’s about to come to an end. Especially as US consumers are being squeezed by stagnant wages, double digit food and energy inflation, and now by consumer good inflation. And if doubts about collateralized credit card loans start to take effect, the apparently endless willingness of credit card companies to extend seemingly unlimited credit to consumers may come to an end as well. The new leg-breaking bankruptcy bill hasn’t repealed the basic reality that you can’t get blood for a stone, and if people are walking away from their houses anyway (and many more will be ) what are you going to seize in terms of assets?–Fight it out with whoever holds the mortgage after default. If you can figure out who that is.
And this contagion will not stay limited to the US. I’ve recently heard talk by fools about how the Canadian economy, for example, has decoupled from the US one. That’s stupid and crazy talk; just because Americans have to buy our oil and electricity doesn’t mean that if our number one trade partner goes into an awful recession or depression we’re going to somehow ride it out. This is true for everyone ”“- China, India, Europe. Even if the US isn’t a particular country’s main trade partner, for the past 7 years the vast majority (over 80% by some counts) of all the world’s savings, have been pouring into the US. When the crap those savings bought gets downgraded into cents on the dollar it is going to cascade through the financial firms and banks the world around; is going to depress foreign consumer spending and is going to collapse worldwide demand. The end result will be a huge wave of unemployment. And as Numerian alludes it will probably start of as a stagflationary wave and turn into deflation.
This, ladies and gentlemen, is going to be a big one. Best case scenario is something like the late seventies and early eighties, which as those old enough to have live through them, were truly awful. Worst case scenario is we’re walking into the next Great Depression.
And if somehow we manage to put it off for a bit longer (we won’t put it off forever) it will because we do two things. We look resolutely up and refuse to look down, which is to say we pretend the paper is worth more than it is. And because we do a massive inflationary bailout of banks and firms by essentially printing huge amounts of money.
But as with Wile. E. Coyote, we can’t keep walking on air forever.. Once you’ve looked down and seen the abyss below your feet, gravity takes over. Too many people have to pretend now that they haven’t seen that the paper is worth almost nothing and fear is taking over. No one wants to be caught with the steaming pile in their laps when the music stops.
It hasn’t stopped yet, but one needs to remember that in early 1930 no one knew the Great Depression was underway either. We’re still looking down, and thinking ”œoh no” and looking to see if with a jump we can grab on to the cliff edge.
I don’t think we’re going to make it. And if we don’t the consequences will go far beyond the economic and into the political. In the early 30′s Americans were willing to do almost anything to fix things. They got FDR, and if he didn’t entirely fix things, he certainly made them a lot better. But they didn’t have to get FDR and a lot of other countries weren’t so lucky.
We’ve made our bad luck, with our fecklessness and our greed.
Can we make our own good luck?