What Really Happened with the AIG Swaps? It's Not What You Think

By now most people who follow Goldman Sachs in the news know that it received $13 billion from the Federal Reserve to liquidate its portfolio of derivatives with AIG. Because the Fed was willing to pay Goldman par value on these derivatives, even though the market valued them at about 48 cents on the dollar, Goldman walked away with no loss whatever from the AIG collapse. This has been described as a great gift for Goldman and all the other banks who dealt with AIG and who were treated the same way. Many others have described this as a colossal rip-off of the taxpayers.

How did this come about? We know a lot more this week about these transactions because of a report that has been issued by Neil Barofsky, the Special Inspector General for the bank bailout programs. The press has described this report as particularly damning of the NY Federal Reserve which negotiated these deals with the banks, and which was led at the time by Timothy Geithner, the current Treasury Secretary. These press reports, however, have mischaracterized what happened and what went wrong. The NY Fed acted properly and entirely as one would expect under the circumstances when they negotiated these contract abrogations. To see what really went wrong, follow along on the details below.

The AIG Transactions

First, a little bit of background on what got AIG into trouble. The insurance giant had a subsidiary in London called AIG Financial Products (AIGFP). This company developed a business that offered customers financial protection on a derivatives contract known as a Collateralized Debt Obligation (CDO). These derivatives packaged together various debt instruments, such as loans, bonds, mortgage-backed securities, even other CDOs, into a single security. When you bought the security, you received a regularly scheduled set of cash flows generated by these debt instruments as interest payments were made. You paid an up-front premium for these cash flows, which usually took place over a three to five year period during the life of the security.

It is interesting to note that the buyer of the security, and for that matter the seller/creator of the security, had no legal interest in the debt instruments. The bonds or loans could be any debt of this nature where public information was known about the interest rate, and whether or not a default had occurred by the debtor. There could be dozens, or even hundreds of different debt instruments bundled into one security.

These CDOs carried a public rating from Moody’s or S&P or Fitch, any of the three big ratings agencies. Also, you could get a daily price on the CDOs from a third party pricing agent located in London. If the price was 100, the security traded at its par value, meaning all payments were highly likely to take place over the life of the security as required by the contract. If the price was 48, on the other hand, it meant the market believed the security was seriously impaired due to defaults occurring on some of the debt instruments in the security.

Big banks loved to create CDOs up until the market crashed in 2007. CDOs were very lucrative. Banks had loan books that gave them a natural portfolio of debt as a start in creating a CDO, but there also was the booming housing market bubble that allowed for the creation of mortgage-backed securities. A huge amount of CDOs were created based on these mortgage instruments. Banks also realized that when they created and sold these securities to earn the profitable premiums involved, they were still on the hook in case any of the debt instruments in a security experienced a default. They wanted to get rid of this risk as much as possible, and pay away a little bit of their lucrative premiums for the privilege.

Here is where AIGFP comes in. AIGFP invented a derivative that acted like an insurance contract. Banks would pay AIGFP a premium, and AIGFP would promise to indemnify the banks in the event they experienced any losses on a specified CDO. The company used a derivative called a Credit Default Swap (CDS, unfortunately easy to confuse with a CDO) to structure this insurance product.

AIGFP was not regulated by any financial oversight agency. It didn’t even have to keep reserves on potential payouts on these CDSs, and even if it did, it has stated that the reserve amount would have been very small because it did not anticipate significant losses on the underlying debt instruments it was insuring. What AIGFP had going for it, and what the banks liked, was that it was a wholly-owned subsidiary of AIG, which carried a Aaa rating in its own name for everything it did. By virtue of this rating, AIG was viewed as one of the highest quality companies in the financial world ”“ almost as safe and sound as a government.

The most common type of CDOs brought to AIGFP were called multi-sector: they had a little bit of everything mixed into them ”“ loans, bonds, mortgage-backed securities on sub-prime mortgages as well as higher-quality instruments like prime mortgages. As long as none of these different types of instruments experienced unusual rates of default, the entire CDO would be traded on the market at a price close to par, and the ratings agencies would have no cause to downgrade the security.

What began to cause AIGFP trouble with its portfolio of credit default swaps backing up about $72 billion of multi-sector CDOs, was not that there were so many defaults on the CDOS that AIGFP had to make large payments under the swaps. The real problem was a series of collateral obligations AIGFP undertook every time it entered into a CDS, and the collateral conditions varied from one swap to the next.

There were three possible triggers for a collateral payment from AIGFP to the banks that bought insurance in the form of CDSs. The first occurred if the underlying CDOs being insured in the swap experienced a drop in price on the market ”“ say from par value to 48 cents. The second occurred if the ratings given by Moody’s or some other agency on the CDOs were downgraded. The third occurred if AIG’s Aaa rating itself was downgraded.

You can now begin to see the sequence of liquidity disasters that befell AIGFP, and soon engulfed its parent AIG, starting in the summer of 2007 and extending until September 16, 2008 when AIG was near death. First, as the market realized that the US sub-prime mortgage business was experiencing very high and unexpected defaults, everyone looked at multi-sector CDOs that carried a significant percentage of these debt instruments in the security. These CDOs began to trade at lower and lower levels in the market as no one was sure just how impaired they would become.

Second, the ratings agencies began to downgrade dozens of CDOs because of the heightened default risk, and the lower prices in the market.

Third, the ratings agencies realized by 2008 that AIG stood behind the CDO market as insurer for the tune of $72 billion. At first, the long term rating of AIG was lowered, and this began a series of collateral calls from AIGFP’s swap customers. Then, by the summer of 2008, the ratings agencies were looking at downgrading AIG’s short term ratings, and doing so by several notches, which brought into question whether AIG could meet all of its obligations under these swaps. This accelerated the demands for collateral on AIG, which was experiencing a very unexpected triple whammy of collateral calls. By September, 2008, AIG had already coughed up an astounding $30 billion in collateral, and was really only half way through what ultimately it would need to satisfy contractual demands for collateral from the market. It simply ran out of resources to raise any more liquidity, and it faced inevitable default under its swap contracts, which would have led to bankruptcy.

This was the situation facing the Fed by the second week of September, 2008.

The Fed Steps In

The Fed already had its hands full in the summer and fall of 2008. First, Bear Stearns collapsed and was thrown into the arms of JP Morgan Chase, but only after the Fed agreed to take over the Bear Stearns real estate portfolio worth $30 billion in dodgy real estate assets. The quasi-government giants Fannie Mae and Freddie Mac had to be taken over by the government, then Countrywide Financial collapsed and also was pushed into a forced sale to a bank.

There was so much criticism directed at the government for the way in which these rescues were being done, and the amount of taxpayer money spent in the process, that when it came time to deal with the collapse of Lehman Brothers, the Treasury and the Fed threw this firm to the wolves on September 15, 2008. It received no help from the government and was thrown into the bankruptcy courts. This precipitated a global market meltdown.

The trigger for this meltdown occurred at the oldest mutual fund in the US, American Reserve Fund, which took a writedown of $785 million on Lehman Bros. bonds it held in its money market fund. This was announced on the afternoon of September 15, and by the close of business that day massive amounts of withdrawals were taking place at American Reserve since no money market fund had ever experienced such a loss (money market funds were supposed to be as safe as checking accounts).

When the market opened the next morning, mutual funds everywhere couldn’t cope with the withdrawals. The commercial paper market ground to a halt, as did the Eurodollar market for short term loans in London. Stock markets around the globe tanked. The global financial system was nearly paralyzed.

The US government stepped in and guaranteed the safety of all money market funds. It allowed Goldman Sachs and Morgan Stanley, the last two surviving old-line investment banks, to become commercial banks and enjoy the benefits of Fed liquidity. The Fed had been working since the previous week on the dire liquidity situation at AIG, and it had asked JP Morgan Chase and Goldman Sachs to form a bank syndicate to provide AIG with a massive $75 billion loan to solve its liquidity problem.

JP Morgan Chase came up with a package that charged AIG an onerous 11.3% on the $75 billion loan ”“ a full $9 billion a year in interest alone. The banks would take an 80% ownership interest in AIG’s assets. This loan package was also intended to stop the ratings agencies from yet again lowering AIG’s ratings, which would have cost the company yet another round of collateral calls from the market.

There was one big problem, though. When the banks looked at AIGFP’s portfolio of swaps, and the potential collateral demands that could still occur, they realized that AIG, if it could sell all of its assets at decent market prices, still wouldn’t be able to meet the liquidity demands. In other words, the way the market was developing, AIG was headed straight towards default and the bankruptcy courts. Making this situation even worse was the global market collapse occurring at the same time as the result of the Lehman bankruptcy. The banks told the Fed that the loan package had collapsed. The banks effectively threw the AIG problem on to the laps of the regulators, none of whom by the way had any legal responsibility, regulatory oversight, or historical familiarity with AIG. It was an insurance company that had somehow become bigger and more important than even the biggest banks.

In deciding what to do, the Fed had about 24 hours from September 15 to 16 to analyze with the Treasury the AIG situation. They discovered that AIG would default on $103 billion in loans from state and local governments, $50 billion in bank loans and derivatives, $20 billion in commercial paper, and $40 billion in insurance covering 401k retirement packages across the US. The problems ranged from the horrendous to the horrific. The municipal bond market stood to be devastated by state and municipal loan losses. The Lehman bankruptcy involved $8 billion in commercial paper losses, which led to the Reserve Primary Fund disaster, but AIG’s commercial paper losses were much bigger at $20 billion. The 401k losses would affect tens of millions of Americans. AIG’s loan losses spread to banks all around the world.

The Fed and Treasury, standing in the middle of a global financial collapse the day after the Lehman Brothers bankruptcy, felt they had no choice but to save AIG, a much bigger player with far greater reach and implications for economic and financial disaster. The Treasury authorized an $85 billion line of credit at the Federal Reserve NY for the purpose of lending to AIG the amounts needed to post collateral behind its swaps at AIGFP. The Fed had no plan in place on how to do this, so it simply lifted the term sheet conditions from the JP Morgan failed loan package, and used those terms to lend to AIG.

From September 16 through October, the Fed lent $61 billion to AIG, over half of which found its way into the market as collateral to support its swaps. At the same time, AIG was instructed to begin reducing its swap book. This required AIG to turn to all the big banks with which it had a swap portfolio, and ask to close out, or abrogate the swap contracts. The banks would consider doing this, but would not want to be then left with the CDO risk that caused it to enter into the swaps in the first place. There was some talk of AIG therefore taking over the CDOs as well, which had sunk substantially in value because of the default risk, but it was very difficult to agree with each bank on what these CDOs were worth. In fact, the banks weren’t willing to sell these CDOs at any discount whatsoever, despite what the market said they were worth, so AIG turned to the Fed for help, and authorized the Fed to negotiate on their behalf.

Here is where we come to the gist of the Barofsky report and the criticisms of the Fed. But let us recap two critical facts up to this point. As of September 15, AIG was certainly heading for bankruptcy, within a manner of days. The banks stood to lose billions on their swaps with AIG, because they would be under-collateralized if the CDOs fell further in value, and because they could not easily all at once get replacement CDS coverage for their CDOs.

Second, shortly after September 16, the banks began receiving collateral from AIG, courtesy of the Fed via the $85 billion loan authorization. For the next two months, the banks were made whole as necessary whenever their CDOs fell in value. The banks could look at their portfolio with AIGFP and consider it safe and secure because of the collateral, and as important, because of the guaranty of more collateral to come as necessary, courtesy of the federal government.

The Fed Tries Its Hand at Negotiating

In early November the Fed assigned a team of managers to begin negotiating for the abrogation of the CDSs. They chose the eight largest bank counterparties to talk to, including Goldman Sachs, BOA, JP Morgan Chase, Deutsche Bank, UBS, and top of the list was Societe Generale in Paris. The plan was to ask the banks to tear up the CDS contracts through a legal abrogation agreement. It was common for banks to do this in the derivatives market from time to time, though never before on a large scale. The banks always required the customer to pay them for any potential real market losses they may incur in abrogating the contract, plus interest and a bit of a fee for all the trouble. Abrogations have never been cheap, especially if the customer was desperate to get out of a deal.

What would the banks want? Collectively, they held CDOs worth a face value of $62.1 billion, and these were the underlying CDOs behind the swaps bought from AIGFP. The banks wanted to give these over to the Fed and get $62.1 billion back, because otherwise the banks would be stuck with CDOs that were unhedged for further default problems.

The market price for this collective group of CDOs was in early November $29.6 billion, which tells you just how badly the market had trashed these instruments. But the banks held cash collateral of $35.0 billion to protect against just this contingency, and if you add the two numbers up, you come to a bit over the $62.1 billion in face value. In other words, the banks were sitting pretty. They were 100% covered for the existing market losses on these CDOs, and the market pricing was beginning to stabilize.

Remember that all this collateral came from the Fed on behalf of the now moribund AIG. The banks wanted to do a simple deal. They would give the Fed all the CDOs in exchange for $29.6 billion in cash ”“ their current market value. They would keep all the existing cash collateral, so they would be perfectly whole. They would then abrogate the CDSs and have no further claim on AIGFP, as if the whole mess never occurred. The Fed, meaning the taxpayers, would be out $62.1 billion in cash to clean this mess up.

In preparing talking points for the negotiations, the Fed reminded each bank that it would be appropriate to give back some of the collateral to the Fed rather than keep it all. The Fed, by stepping in a month earlier, had saved the banks from billions of losses had AIG gone into bankruptcy, and these losses might have included a systemic crisis in which a few other banks went under and couldn’t pay their obligations as well. ”œ”Be nice to us, given all that we have done for you,” was the Fed motto.

The Fed then tied the hands of their negotiators in several ways. First, the Fed would not threaten to throw AIG into bankruptcy if they didn’t get a ”œhaircut” on the $35 billion in collateral. This would be unethical because the Fed had no plan to put AIG into bankruptcy and everybody knew it. Second, the Fed negotiators would have to do the same haircut deal with everybody. If Goldman Sachs agreed to return 30% of the collateral, JP Morgan Chase would have to agree to the same thing. Third, the banks were told up front that their participation in the negotiations was entirely ”œvoluntary”; nobody was going to be forced to do anything or accept any haircut.

You should not be surprised that seven of the eight banks refused to take any haircut on the collateral and would therefore return none of it. They argued the cash was theirs, not the Fed’s, and they owned it by the sanctity of a legal contract that the Fed was proposing to violate. Second, AIGFP was not in default and there was no bankruptcy, and there wouldn’t be any, so giving back collateral when there was no legal requirement would constitute a breach of fiduciary duty that the banks had to their shareholders. Unstated in all this was the fact that the Fed wasn’t threatening any consequences if the banks refused to give back any of the collateral.

The kicker that destroyed any possibility of the Fed getting some of the collateral back occurred with the French bank. They told the Fed that it was not simply a fiduciary responsibility they had to follow in keeping cash that was rightfully theirs ”“ it was decidedly against French law to give back the collateral because there was no bankruptcy. The French regulators confirmed this in no uncertain terms to the Fed, with the implication that if the Fed pushed on this point relationships with the French government would be damaged. Remember that all the banks had to agree to the same deal, so each bank had a veto power over any deal, and the French bank had the ultimate veto ”“ it was illegal for them to give back the collateral.

The negotiating team reported all this back to Timothy Geithner, and recommended that the Fed settle all the swap abrogations by allowing the banks to keep all the collateral and thereby effectively receive par value on contracts that in the market were worth less than half that. Geithner agreed and the deal was done. The Fed then promptly kept all these details secret, including the names of the banks involved, and even went to court to maintain this secrecy under the financial equivalent of a ”œstate secret” argument. They recently lost this argument on appeal to a higher court, and the Barofsky report severely berated the Fed for this because no terrible consequences have occurred now that the details are known.

What Went Wrong Here?

The Barofsky report lays a pretty heavy blanket of criticism on the Fed for not just the secrecy of their actions, but the actions themselves. The Fed didn’t have to treat everyone all the same. It could have accepted different levels of haircuts. It didn’t have to put so much faith in the sanctity of contracts when AIG was in virtual suspended animation ”“ bankruptcy in all but name.

These criticisms do not show an understanding of how the Fed works. Like any large American organization, it pays considerable attention to the law. Timothy Geithner had a high powered, high-priced General Counsel sitting as his right side all the way. Geithner was told clearly that as long as AIG was not in bankruptcy, the Fed might damage its reputation by violating the terms of perfectly sound legal contracts and insisting on repayment of collateral when it was not legally required. He was also told the Fed had no ethical right to threaten bankruptcy when the threat could not be backed up later in court with proof it was real. He was probably told ”“ though there is no proof of this in the report ”“ that giving any bank preferential treatment on haircuts exposed the Fed later to lawsuits of unfair treatment.

Timothy Geithner is like most American executives ”“ he is a technocrat. He respects technical advice, especially of the legal kind, and he abides by it. Past presidents of the NY Fed might be different ”“ Gerald Corrigan comes to mind during the Drexel Burnham bankruptcy. He would bang some heads together to get an outcome that satisfied the political pressure on the Fed, even if it meant overriding legal advice. Gerald Corrigan, by the way, now works for Goldman Sachs. He might have in this situation taken Goldman Sachs and JP Morgan Chase aside and said, ”œI want you guys to get your consortium of banks to agree on a haircut ”“ something like 30% would be nice ”“ and I want all of you to come back and voluntarily request that the CDS collateral provisions be waived in favor of paying back to the Fed some amount of the collateral. I don’t care how you do this, and it is not going to be the Fed asking for it ”“ it is going to be voluntarily offered to us.” The banks would not need to be told that there was a steel hand underneath the Fed’s velvet glove.

Maybe Timothy Geithner would have done this, technocrat though he is, if there were enough political pressure on him to save the taxpayers billions of dollars, but there wasn’t. No one in the Bush administration ”“ certainly not Henry Paulson at Treasury ”“ was demanding fairness for the taxpayers. There was public disgust over the whole bailout process, but this disgust got bottled up in a Congress paid for by the financial industry. Barofsky might have mentioned that lack of political pressure, and the consequent insensitivity to taxpayer needs that the Fed and the Treasury displayed, but he didn’t, maybe because his current paymaster, the Obama administration, isn’t showing any such sensitivity either.

Which brings us to the crux of the problem, only hinted at in the Barofsky report. The real problem for the taxpayers didn’t occur when the NY Fed failed to negotiate the return of some of the collateral in November, 2008. The problem occurred on September 16, when the Fed and the Treasury were suddenly faced with a collapsing AIG. Had there been any forethought and planning for such an event, the reaction could have been very different and far less panicky.

The first response should have been: ”Financial markets worldwide are frozen, and they are going to stay frozen for a long time no matter what we do with AIG.” In hindsight, this is exactly what happened. The commercial paper market has taken nearly a year to recover a fraction of its previous activity, and this was only after the Fed had to guarantee transactions. Credit spreads took nine months to begin coming down to normal levels. Banks are lending to each other only because governments around the world now guarantee their bank activity, but banks are still not lending to corporations, small businesses, or individuals. The housing market in the US exists entirely on the generosity of Federally-managed firms like Fannie Mae, Freddie Mac, and FHA. In other words, the disaster that the Fed faced on September 16 rolled on despite the rescue of AIG.

If AIG had been allowed to fail, the market would have learned a serious lesson about dealing with companies that act like banks but really have no controls or regulatory oversight like banks. The pain would have been greatest at the banks themselves. Some banks like Citigroup and Bank of America would have been even more crippled than they are now, but their current status as zombie banks would not be any different. The damage done to 401ks could have been mitigated by additional federal government guaranties, but even here the cost while enormous would have been less than what was spent paying off AIGFP’s credit default swaps at par.

Suppose you say that it is impossible to expect government bureaucrats to react on September 16 in any different manner. You can argue that any normal person would have panicked too, and that tough-nosed regulators like Gerald Corrigan don’t come around all that often ”“ in fact these days they are all working for Goldman Sachs. Fine. Where, then, was the prudential planning for this catastrophe. All it would have taken is someone in advance of the crisis ”“ a clever lawyer for example ”“ inserting one clause in the agreements with banks before any collateral was posted with them. It would have said ”œThe Federal Reserve Bank of New York reserves the right at any time to demand immediate repayment of any or all amounts of collateral posted with Bank X, with no compensation required to be paid to Bank X in any form by the Federal Reserve Bank of New York, and Bank X hereby waives all rights to petition for a legal stay of said repayment.” If the banks didn’t like this clause, they wouldn’t get their collateral. They could go ahead and sue the government for breach of contract, but in the meantime they would be experiencing real pain with their CDO portfolio and the pressure would be on them to settle. Once the collateral was out the door, the Fed lost all leverage with the banks, and this is why the November negotiations were a foregone conclusion and a waste of time.

Finally, what is fundamentally missing at the Fed and the Treasury, and certainly now with two successive administrations and almost all 535 public servants in Congress, is the sense that the big financial institutions which have created this monstrous mess are dispensible. The problems that have arisen due to their avarice and misjudgments are only going to be solved over time, and are best solved in bankruptcy courts or through FDIC closure processes, not by making these institutions wards of the state until 10 or so years later they are nursed back to health. The public can and has been protected through deposit insurance, but the collapse of lending and credit in general has not been mitigated one whit by anything done so far to rescue these institutions. Let them die a merciful, quick death if death is their fate anyway. We will all of us individually benefit from such mercy as well.

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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, jehoshuathebook.com.

24 CommentsLeave a comment

  • The knowledge, the organization, the clarity of language, the patience in writing it out and the obviously many edits it must have taken to get the structure so well done, the spelling, the grammar, the consistency of the nouns, all of it. Just amazing.
    I’m sending the link to each of my representatives (?), federal and state, and to everyone else I email with. Let’s see what happens.
    Thank you.

    “All I know is just what I read in the newspapers.” – Will Rogers

  • “Finally, what is fundamentally missing at the Fed and the Treasury, and certainly now with two successive administrations and almost all 535 public servants in Congress, is the sense that the big financial institutions which have created this monstrous mess are dispensible.

    The institutions may be dispensible. Their payments to congress are not, and there was no easy replacement income available to congress persons.

    I’ve been and continue to look at the raw data from opensecrets.org, as I thought I’d try my rusty math skills. I like significance, and population tests (chi squared tests).

    I have the data reduced to 600 rows in table, with aggregate, means and standard deviations, and now need to think about chi squared analysis analysis and then presentation…

    An early outlier? Virginia and Eric Cantor. There is somthing very different (I hesitate to call it “wrong”) about VA and Eric’s individual contributions.

    The numbers are: Eric receive $954,500 in individual contributions, the next best is Joe Donnelly, IN02, at $226,300, and the overall hous mean is appox $3300.

    I have not run signifigance tests on Eric, but this number is an outlier and stands out. “Off the charts” is a good description. Also Eric is the only, repeat the ONLY, member of the House whose individual contribution are greater than their PAC contributions.

    Data from http://www.opensecrets.org

  • …take a look into your crystal ball. Will this situation inevitably lead to Japanification? Will the U.S. have a “lost decade” ? Will there be another crash? Have they learned, or would they do the same thing again?

    (Oh, and please fix the spelling on “guarrantee” in a few spots)

  • Congresspeople are known from time to time to read stuff like this.

    I should say, the original Barofsky report is well written and a model of excellence in comparison to the usual government reports.

  • Cantor sounds like a real outlier on individual contributions, but on the other hand he is said to be a rising star and just may be pulling in this money nationwide. A lot of corporate money does come in the form of individual contributions from employees encouraged to give up their personal limit to certain politicians.

  • We are well on our way to Japanification. It is the defacto policy of the government to save the big banks at all costs, even if it takes a decade of hiding their bad assets to wait for them to build up enough capital to survive.

    To see this, look at the different behavior of the government during this crisis. Supposedly, Treasury and the Fed got really tough with BOA when they forced them to buy Merrill Lynch. Why? Because the goal was to save Merrill Lynch any way possible, and if pressuring a bank was the way to do so, so be it. But then these same people got all wishy-washy when it came to the AIG bailout. Why? Because the goal was to save AIG any way possible, and if caving in on the swap abrogations was the way to do this, so be it. Different behavior, indeed, but the same goal – save the financial firms from collapse and the supposed awful consequences for the market. Pain avoidance just like the Japanese practiced throughout the 90s. It’s funny how two different governments and completely different cultures fall into the same trap.

    Which is why a worse crash is coming. Think of it this way. Haven’t you lived through this movie once before from 2003 to 2007? We are right back to having Fannie and Freddie goose up the housing market any way possible, even if we have to give $8,000 bribes to homeowners, and even if we have to add FHA to the mix, with their very familiar 3% downpayment mortgages with no verification of income or assets required. We have exceptionally low interest rates – as low as they can go – with the Fed once again telegraphing everyone as clearly as possible that they aren’t going up for a very long time. Last time, it was an invitation to the banks to short fund their portfolio and makes lots of money. Now it is also an invitation to speculators all around the world to short the dollar and invest in anything that is going up. So here we are back again with bubbles erupting all over the place. Copper is up over 100% in the past six months. Emerging markets have soared. Real estate in Hong Kong is setting record prices. The Dow is up over 60% since March. Gold has gone from $800 to over $1100, and the only reason anyone buys something that pays no interest and costs you to carry it is because it is going up in value. And what does the Fed say to all this, and to its deliberate policy of driving down the dollar? “We see no bubbles. There are no misalignments in our markets.” Alan Greenspan is brutally honest now that he is no longer at the Fed – he welcomes all this frothy irrational exuberance in the market because it gives people a sense of well being plus some money to spend. That is a classic definition of an international financial order gone amok.

    The next crash, which can come any day now or a year or two from now, will be something to tell your grandchildren about. It will dwarf what happened in 1929 because the whole world is wrapped up in this financial mania, and governments everywhere are pushing it higher and higher until it bursts. They simply don’t know any better than inflating assets as some sort of magical answer – this time using government debt and taxpayer money to fund the bubbles.

    By the way, I haven’t found misspelled “guarrantees” in the paper. Could you point them out? I use guaranty as a noun, and guarantee as a verb. Maybe you are referring to these as inconsistencies.

  • Sometimes I wonder, other times I know. One of the Cardinal rules in any type of negations is the trap door clause, like the one you mentioned be inserted into any agreement. These so called heavyweight Goldman Sachs negotiators failed in the most basic element of risk reduction. They failed, straight up. A failure of this basic tenet of negotiations, is like forgetting to take your car key out to start the car, it’s that basic. No key, no start the car. No escape clause, no deal.

    All these Goldman Sachs gents will live very nicely, thank you. Their great grandchildren thank you in advance.

    “There are two types of folk music:
    quiet folk music and loud folk music.
    I play both.”

    Dave Alvin

  • Well, I’ll be. Guaranty *IS* a noun. And guaranties *IS* the plural of that noun. You’re right. I had never seen that word before. Now I have two things to thank you for – this post and the spelling lesson!

  • Numerian, are you making a book from all these incredible posts you have put up here on the financial situation?

    You should, and it should be required reading at business schools worldwide, I’m thinking.

    You are the Babe Ruth of financial bloggers.

  • I’ve read all of your posts, Numerian, and they are all good but the last few are concise such that they uniquely articulate and analyze what is happening. No such commentary exists elsewhere; that I can find anyway.

    We need a NATION WIDE STRIKE for Real healthcare reform

  • You should remember, I have some of the richest material to work with in a lifetime. The problem is more what should be left out of the narrative, there is so much juicy stuff going on.

    I fear the writing material in coming months is going to get much more compelling.

  • In the second quarter 2009 annualized real GDP growth declined at a 6.4 percent rate. In the just-ended third quarter 2009, real GDP growth rose at 3.5 percent. Therefore, in only six months, real
    economic growth has improved by almost 10 percentage points—far faster than a consensus sold on depression could fathom!

    At the start of this year, both the services sector and manufacturing
    sector ISM surveys were at record lows. Today both are well above the 50 percent expansion level.

    After collapsing for years, housing reports show an industry that is
    improving steadily. Existing family home sales have surged by 24 percent from January lows, new single family housing starts have risen in six of the last seven months by more than 40 percent

    Retail sales, after free falling in 2008, have increased in six of the last nine months and are up by slightly more than 3 percent year to date! A truly unbelievable turnaround for 2/3’s of the economy.

    Corporate profits have risen each quarter this year, and company reports have exceeded expectations in every single quarter.

    The surge in the U.S. leading economic indicators index since its March low can only be described as sharply rising line. It is what no one has predicted “V-shaped”!

    This is not a stock market ahead of its fundamentals—it is a cultural mindset that simply can not process how fast the economy has recovered from the “depression” we were in and how well the economic advisors, the Fed and dare I say Government responded. This is a spot on intervention that revived the economy.

    The nation has been sold on and accepts that this is so bad we can never recover, that everyone in Government is inept. In light of such a worldview, how can it be possible to find that the disaster and depression that was such a sure thing, gives way to horror of horrors – A recovery!!

    The shock of the Lehman collapse one year ago has been equaled by the shock of a postcrisis economic recovery!!??

    What is left to do but to pick over this carcass of doom and gloom and try and revive it, so a false world view can be clung to even as the recovery unfolds.

    Sorry guys, the data is so steadily improving, and so many positive indicators. Profits, growth, jobs will all show growth beyond expectations for at least the next two years. Enjoy the continued doom and gloom.

  • 🙂 Your ability to wade through all the muck and to present the information in such a easy to understand way is amazing. I however fear for your fear, but look forward to reading more. Thanks for all your great posts Numerian.

  • This is truly an amazing post. I’ve been studying it since it went up. Your point on what could have been expected from regulators and the lack of simple competence is very good. Barofsky could be the intrepid sleuth who doggedly pursues his target through the sewers of DC. In his July 21, 2009 statement, Barofsky concluded: “Failure to impose a wall [between the PPIF fund managers making investment decisions on behalf of the PPIF and those employees of the fund management company who manage non-PPIF funds]… , will leave Treasury vulnerable to an accusation that has already been leveled against it — that Treasury is using TARP to pick winners and losers and that, by granting certain firms the PPIF manager status, it is benefiting a chosen few at the expense of the dozens of firms that were rejected, of the market as a whole, and of the American taxpayer.” Can the insiders resist this temptation? Another political/behavioral question.


  • I learned early on to admire economists or financial advisers or traders who expressed a cogent, thought-through view of what could happen in the markets and the economy. It beats the usual hemming and hawing, it’s what helps make a market, and of course takes some guts. You are certainly right that we have any number of indicators showing a V-shaped recovery, and nobody could say for sure whether this will continue. I happen to think it won’t, but have said that the reflation that is underway by governments worldwide, is absolutely unprecedented and therefore could lead to several years of continued growth, possibly explosive in areas like Asia.

    This does not necessarily make the doom and gloom crowd wrong, because at the end of this reflation could lie a deflation/depression much worse than what was seen in the 1930s. The criticism of The Depressants, let’s call us, could then be one of timing, just like in 2004, when many of us were identifying a massive housing bubble but were a small minority until three years later.

    For The Depressants to be wrong, we need a number of things to happen:

    1) The US needs to remove its $8,000 homebuyers subsidy, and FHA has to get out of buying mortgages with 3% down and no income required. It is too much to ask that Fannie and Freddie be privatized, but at the least they should not be allowed to finance any mortgage for more liberal terms than they are currently accepting. In other words, no further propping up the housing market beyond what is happening now.

    2) All financial support for financial firms must be withdrawn and we must go to ex post ante the 2007 crisis. This includes eliminating the FDIC coverage of mutual funds, the TARP program, the FDIC guarantee of bank bond issues, the support of the commercial paper market, etc. The Fed must within two years sell all of its mortgage paper and assets bought from the banks, and close down all the Maiden Lane portfolios. The Fed balance sheet must get back to $800 billion of Treasuries only, which means all agency securities must be sold at whatever the market will bear and no more new purchases allowed. All excess reserves put into the banking system since 2007 must be withdrawn.

    3) No more bank rescues shall be allowed and too-big-to-fail will be cancelled. The mark to market rules applying to banks until 2009 shall be restored.

    4) CIT will receive no more funding from the government.

    5) GM and Chrysler will have to pay back their loans within the next two years.

    6) No more cash for clunkers or any similar program for appliances, etc.

    7) Goldman Sachs and Morgan Stanley will return to investment bank status if they wish to persist in their present business model, which is that of a hedge fund rather than a commercial bank.

    8) Negative real interest rates will not be allowed, which means Fed Funds will have to get back to at least 2%.

    9) These measures above will help reduce the federal deficit, but within two years in any event it should be lower than where it was when Obama came into office.

    10) The stimulus programs in all other economies will have to be withdrawn in a similar fashion on the same time scale, especially in China.


    In other words let’s get back to the world as it existed in early 2007 before all this monetary and fiscal stimulus was applied. Let’s also put on a whole new set of controls on the financial industry, including hedge funds and private equity, to keep leverage below 10:1 and to eliminate asset stripping and other examples of equity extraction like HELOCs. If we can then get a global economic recovery like we used to see in the 1950s – 1970s, where excessive levels of debt were not necessary to push growth; and if the financial sector can go back to contributing about 7% of total corporate earnings rather than 30%, I will retire from the gloom and doom crowd.

  • We would have crashed harder and deeper without the various stimulus plans that have been enacted. And all our problems can’t be laid at Obama’s feet. He inherited an untenable situation.

    However, your guess concerning our future is a guess like anyone else’s.

    We’ll see.

    Don’t be surprised if bush’s legacy doesn’t end with a big old W stamped on our economy before this is over, accent on the second half.

    I’d add that perspective has a lot to do with how one perceives things. It’s not a bad time to be a Wall Street trader at the moment, but if you’re part of the 22 per-cent currently unemployed or running a small business, your view will be quite different.

    When I look for examples of this turnaround you describe in the piece of the world where I live, they’re very hard to find, almost to the point of being non-existent.

    I did inhale.

  • Sobering isn’t it? However if capital can be reallocated to innovation a recovery like this gains legs. I never thought the allocation to housing as occurred was a good use of capial. I used to say there is no innovation in putting up sticks. Also the capital markets were no where near normal in 2007. At the same time several supports can remain a long time like programs keeping down payments low and I honestly don’t see any real difference with Fannie and Freddie except an open acknowledgement of the fed guarantee. I like the present structure better. It was frankly an awful institution before.

    I would add to your excellent list reining in derivitives, regulating syndication, and anti trust on any institution showing systemic risk if they were to fail. What everyone calls too big to fail.

    Then we can add getting rid of interest deductions so there is not this systemic bias to debt. House prices are to high and indebted businesses are rewarded by the present tax regime.

    Like you say we will see but I see this recovery moving capital back to innovation and manufacture like I have never seen before.

  • Sorry, my mind is somewhat slow moving but methodical…

    Since the co-called turnaround began, if you measure GDP against oil or gold, figures don’t look good, even stock market gains. The price of oil has doubled since its lows; gold has also gained in value against equity markets.

    It’s a whole lot harder to make more gold, oil, (and food) than it is to create new money.

    I did inhale.

  • We are both in agreement that we want to see an economy that operates without the artificial props we are so used to, including the new ones to which we are fast becoming addicted (extension of the $8,000 housing credit, for example, and expansion to include all home buyers).

    I would also agree with you that the way out is best achieved if we can redirect economic energies to innovation, especially in the US which has lost its ability to sell goods and service to the world at attractive prices with meaningful value provided. I think though, that there are some deep problems with this challenge because of globalization, and that all industrial countries are going to be struggling for years to get back their export prowess and compete with China and others.

    Don probably says it best: we will have a big fat W stamped on our economy before this is over, and the second leg down will be stunningly painful. That I guess is where we differ.

  • I remember reading a while back that the best thing for GM might have been a “structured bankruptcy,” whereby the US government steps in as a pseudo-creditor to guarantee SOME repayment of debt, but the company still legally is bankrupt. That way, the government can legally cram down debts.

    Why was this not done for AIG?

    I understand why bankruptcy was not an option… that would lead to serious financial panic, and going through bankruptcy courts could take 18 months. But why not do a structured bankruptcy, whereby the government guaranteed some repayment of debt to maintain market liquidity… but could legally demand the French banks accept 50 cents on the dollar?

    Would that have been a bad idea? Why didn’t the Fed do it? Were they incompetent, corrupt, or am I missing something?

    Of COURSE you can trust the US Government! Just ask the Indians.

  • You really have put your finger on the central point. A bankruptcy would have forced the French banks to accept whatever the bankruptcy court or judge adjudicated. There are well-established rules in such cases to deal with foreign claims. US claimants would have received far less than par value as well and the taxpayers would have been spared all sorts of trouble.

    The only explanation the government can provide is the systemic risk argument. If AIG could not pay Bank of America what it was owed, the amounts are so large that Bank of America would not have been able to meet its obligations to others, and a cascading series of bankruptcies would have rippled through the system. We’ll never know the truth of this because it didn’t get a chance to happen, and no one has their finger on the global systemic risk. Which is still unresolved. None of the solutions for a systemic risk regulator talk about the need to get complete data from at least the top 25 largest banks and investment banks. Moreover, when someone like AIG crops up who is out of the banking system but clearly absorbing huge amounts of financial risk on their shoulders, they need to be brought into the systemic risk pool as well.

  • Lucky the organ didn’t short itself out, what with all the bubbles soaping up the keyboard.

    Yet another cautionary tale of the use of bubbles for special effects.

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