It’s time for a little dose of reality. We are daily bombarded with rants from both sides of the political spectrum as we try to sift through the information concerning how the deficit in this country got out of control. To have any sort of perspective on the problem we need to go back to 2001 when Bill Clinton was leaving office. At that time the Congressional Budget Office estimated that the US budget would actually run a surplus of some 800 billion dollars a year for the years 2009-2011. What has actually happened is that we are now running an annual deficit of some 1.2 Trillion dollars a year for those years. This difference in these two amounts is a 2 trillion dollar headache for the United States and one that the current crop of politicians on both sides are steadily proving themselves incapable of understanding, much less rectifying the situation. What happened? How could the Congressional Budget Office have been so far off in their estimate?
Republicans would have us believe that the Obama administration with its socialist tendencies and out of control spending habits has destroyed our economy. Democrats would have us believe that tax cuts for the richest Americans and lobbying efforts by the largest American corporations have decimated the ability of the US to raise revenue needed to pay our bills. As is usually the truth in politics, there is a grain of truth in both explanations but neither of them addresses the real problem, which is that our economy is suffering from of one of the worst economic disasters in the history of financial disasters. I have already addressed these issues on several posts (What Really Happened, Magic Beans, A Swing to the Right, Tax Philosophy ) so I won’t bother to go into them in a great deal of detail again but we have to understand the problem before we can come up with a solution and the soapbox prima donnas on both sides of the aisle are either incapable of understanding the issue or unwilling to deal with the reality that we are in serious trouble here and it is not going to be easy to put the pin back in the grenade.
Let’s take a look at where the deficit numbers come from, the discrepancy between what the CBO predicted and what we actually have taking place right now. The largest part of the difference came from two unexpected economic downturns. The first happened in 2001 and was a small recession compared to the second one but it was a downturn and it affected projections of both spending and revenue. When the economy goes down and unemployment goes up two things happen at the same time. The money the government takes in from tax revenues drops and the money it pays out in social programs goes up. Unemployment payments, welfare payments, Medicaid payments, and all forms of social services bear the brunt of the fact that people who aren’t working become dependent on social programs to survive. At the same time, tax revenue that isn’t being generated from these same people goes down. It is a double edged sword; one made worse by the fact that most Americans health insurance is through their employer so when they lose their job they lose their health insurance as well and the government then gets to foot the bill for their medical expenses. The second economic downturn which started in 2007 right before the election that put Obama in office was much more severe and much more damaging to both the US economy and the budget deficits because of both the longevity of the downturn and the universal severity of the problem.
Clearly, Obama can hardly be blamed for the economy he inherited no matter what the conservative right would have us to believe. It happened before he was elected and he is still trying to deal with the effects of this problem. We can argue whether he has dealt effectively with the problem but it is incontrovertible fact that the problem itself is one that he inherited from George W. Bush and the Congress in place while he was in office. How much of the current deficit problem is directly attributable to this economic downturn is a matter of some disagreement but most economists agree that it is by far the largest part of the current deficit issue; in the range of some 37% of the 2 trillion dollar deficit miscalculation of the CBO. This means that some 740 billion of the difference between the CBO’s estimates and reality is a direct result of the economic downturns that occurred before Obama’s election.
Another large chunk of the problem came from two programs that George W. Bush pushed through Congress. You remember him and his buddy Cheney who confidently boasted that Reagan had already proved that deficits don’t matter. While this is obviously a remark made in total ignorance of economic reality, it is part of the the same fable that Republicans have been telling since Reagan was in office. According to the Republican mantra that has been around since Reagan the answer is cutting taxes no matter what the question might be. Cutting taxes stimulates the economy which allows it to produce more revenue according to Reagan’s idea of economics which the first Bush president accurately described in a debate as “Voodoo Economics”. Unfortunately, he neglected to explain this fact to his son who believes to this day that what we need are more tax cuts for the wealthiest Americans. The truth is that the Reagan years doubled the deficit which is something that was deemed impossible previously without a major war like WWII. I have trouble understanding how even the most ardent Reagan worshipers gloss over the fact that he doubled the deficit in peacetime the first time we tried tax cuts for the wealthiest Americans. As a matter of fact, cutting taxes didn’t stimulate anything but the second phase of Reagan improvements which involved spending massive amounts of government money paying large corporations to develop military hardware did. This is exactly why the economy took off, it was the largest influx of government money into the economy we had seen and it worked like a charm as long as you ignore the fact that it doubled the deficit.
Getting back to the present situation, George W. Bush pushed through two major programs that had devastating effects on the deficit. The first was the Reagan mantra of cutting taxes on the wealthiest Americans. This of course had the same effect that it had in Reagan’s years; it caused a loss of tax revenue that led to significant deficit increases. Interestingly enough, Republican believers in the tax cut mantra still believe it is the answer today even though we have a lot of statistical data that proves it takes increases in revenue along with decreases in spending to lower deficits. All one has to do is compare the Clinton and Bush Sr. years to the Bush Jr. and Reagan years to see this in action but it really is as simple as addition and subtraction. Any child knows you don’t increase the amount of water in a bucket by punching a hole in the bottom of it. The second program that Bush pushed through was the Medicare Prescription Drug Act which basically increased the amount the government program would provide for paying for drugs for Medicare participants. While this is a much more noble cause than tax cuts for the wealthy it was implemented without a hint of how it was to be financed so naturally it just added to the deficit. The net effect of the Bush Tax cuts and the Prescription Drug Act changed the CBO’s predictions by some 33% (660 billion dollars of the 2 trillion) by the time the increases in interest payments on the debt it created are added.
If you add the 33% to the 37% you come up with some 1.43 trillion of the difference between the CBO’s prediction and what we are actually seeing. Try to keep in mind that this number is composed strictly of policy mistakes that were put in place before Obama’s election. It is interesting that the harshest critics of the deficit issue today are some of the same people who actually caused both of these problems to happen through de-regulation of the financial industry and tax cuts for the wealthiest Americans along with a Prescription Drug Act that was passed without any hint of how it would be financed.
Does this mean that Obama has no blame in the current fiasco? I would say that there is enough blame to go around for everyone but we will continue to look at actual numbers to see where the 2 trillion dollars difference between the CBO’s estimate and today’s reality was created. Another 20% of the difference can be found in Obama’s support for the continuation of the wars in Iraq and Afghanistan combined with the continuation of the Bush tax cuts along with the Wall Street Bailout that Bush signed and Obama supported. In other words another 400 billion of the 2 trillion dollar difference can be traced directly to these three policies that Bush put in place and Obama continued to support after his election. Many of Obama’s supporters were disappointed with his continuation of the wars in Afghanistan and Iraq. Without knowing the security information that Obama became privy to upon arriving in the White House it is hard to make judgments about his decisions along these lines. We can further question his support of the Wall Street bailout but most reputable economists believe that it was necessary to keep the international economy from a devastating collapse; one that we are still not completely sure won’t happen in the near future I might add. Extending the Bush tax cuts was unmistakably a bargaining tool that Obama used to get support for some of his other programs but I personally believe it was a bad deal and one that can be shown mathematically to have increased the deficit problem when we need to go the other direction. In any case, if you add the 400 billion to the 1.43 trillion above you come to a 1.83 trillion dollar figure or some 90% of the current deficit problem and we still have not gotten to any of the Obama programs that conservatives want to convince us are the root cause of the deficit.
Obama is not without blame in the current crisis. The stimulus bill that he helped push through Congress to get the economy going added another 7% to the difference between the original CBO estimate and the 2 trillion dollar deficit we have. Obama’s health care bill that he pushed through has also added to the problem, along with his initiatives on education, energy, and other social programs added another 3%. In other words, Obama’s programs which conservatives see as the socialist part of his agenda have added a total of 10% (200 billion) to the deficit problem.
To recap; policies and economic problems that occurred during the 8 year term of George Bush are the direct cause of 70% of the deficit problem we are faced with. Obama’s support for/ and extension of Bush policies added another 20%. Obama’s programs that he has personally pushed through add another 10%. The end result is that we have a 2 trillion dollar difference between what we should have in our deficit and what we are actually faced with and we are now faced with the reality that we have to deal with this issue before it gets any larger. There are only two ways to decrease the deficit, increase revenue and decrease spending. Unfortunately, we are now faced with such a severe problem that we will probably have to do both in large and painful increments to see our way clear of this issue. There is always the possibility that the economy will turn around and start to grow at a fast rate which will necessarily narrow the difference between what we take in and what we spend. Unfortunately, the deficit issue has grown to such proportions that growth is probably not possible without first cutting into the deficit. It still remains to be seen whether we can change our economic policies to actually deal with the issues that caused the economic collapse that triggered the biggest part of the deficit.
Showing posts with label Economy. Show all posts
Showing posts with label Economy. Show all posts
Tuesday, July 19, 2011
Wednesday, January 5, 2011
What really happened.... a virtual tale
Something happened to our economy in this country in September of 2008. Something happened that was so unusual, on such a large scale that it prompted the head of the Federal Reserve and the Secretary of the Treasury of the United States to decide that drastic measures were necessary to avoid an unprecedented economic collapse. I have already established that it wasn’t the housing industry collapse. The numbers just don’t add up. It is beyond argument that the sub-prime mortgage debacle would only directly contribute some 42 billion dollars in bad debt which could not possibly create the need for an emergency injection of federal funds that wound up totaling almost 2 trillion dollars and counting. As I stated before, if it was the sub-prime mortgages that caused the whole problem we could have cleared that off the books by simply paying them all off with a small fraction of what we have already spent. What we are actually talking about here is the difference between a cause and a catalyst. The sub-prime mortgage collapse was a catalyst for the collapse. The cause of the collapse is much more complicated.
The answer to the riddle is not simple. I have already touched upon it briefly in a previous post but want to delve into the subject in a little more detail now. I personally started looking into this issue several years ago because the numbers simply didn’t add up in my own mind. I have spent quite a bit of time since then studying; poring over books and articles that seemed alternately needlessly complex and ruthlessly simple. I would like to try to break it down into terms that are easy to understand but I am aware that may not be possible. Still, I think it is worth the effort to make the attempt.
The first financial instrument one has to understand to make sense of this mess is a Credit Default Swap or CDS. A CDS is simply a way of selling debt by insuring it. CDS’s were basically invented in the early 1990’s as a means of freeing up capital. The germination for the idea for CDS’s came to fruition when JP Morgan Financial Services was in the process of trying to figure out how to loan money to Exxon in 1994. At the time Exxon was facing punitive damages stemming from the crashing of the Valdez in Alaska. Facing large damages and falling stock prices Exxon was in something of a financial bind at the time. Ordinarily, such situations are handled by high interest loans as banks feel they deserve more profit for making riskier loans. Even though Exxon was a huge conglomerate and showed little possibility of financial collapse as a result of the upcoming high fines they were expecting they didn’t have enough cash on hand to handle paying such fines without selling off something which would have only served to drive their stock prices even lower and make the loans riskier. JP Morgan came up with a rather unique solution to the problem. They loaned Exxon the money, some 5 billion in all. However, JP Morgan didn’t want to tie up all of their capital on one loan that may or may not be the last money Exxon needed to weather the storm after the accident so they were interested in selling off portions of the debt to other investors. The problem with this line of thinking was that there were very few financial institutions able to withstand such a large debt on their books.
JP Morgan executives then sold the risk on the loan to the European Bank of Reconstruction and Development which basically cleared the debt off of their books while they made also made a percentage for brokering the transaction. The whole process started a chain reaction of ideas within JP Morgan and the rest of the financial institutions around the world as they studied the feasibility of making loans while at the same time avoiding holding the debts on their books. It seemed eminently profitable to find a way to broker deals for such loans while at the same time avoiding holding long term debts on their books which unavoidably cut into the capital they had available to make the loans to begin with. This is much the same fascination that the middle ages had for alchemy. Just substitute the term “debt” for iron and “asset” for gold and you have the general idea. What could be better to a financial institution than the ability to instantaneously turn a debt into an asset?
It wasn’t long after this that another artificial construct along the same lines began to come into favor in the mortgage industry. Collaterized Debt Obligations are structured credit products that were supposed to increase the availability of credit by leveraging the amount of money available for such loans. In short, a CDO in the context of this discussion is a bundle of home mortgages that is sold as an asset. If you think this seems a little like magic you are not very far from the truth. Lending institutions have always been limited to loaning out a factor of the money they have in reserve (their depositor’s savings) in case the loans go into default. It is really a matter of common business sense that any financial institution can only lend out a finite amount of money because it has to hold a small percentage of these loans in the form of capital to support such loans in the event of defaults. Obviously, there are rules and regulations to this effect and the Federal Deposit Insurance Corporation that guarantees depositor’s money is officially responsible for enforcing such restrictions in this country.
With the advent of CDO’s, lending institutions could bundle up groups of mortgages and sell them as assets to insurance companies, pension funds, hedge funds, and investment banks. While the lending institution thereby only made a percentage of the total value of the loan, it was an instantaneous profit while it simultaneously cleared the loan from their books. This freed up their committed reserves so that they could then lend the same reserve out again and again. It is worth remembering that a mortgage based CDO is actually a bundle of debts. While this bundle of debts certainly has a marketable value it is still a bundle of debts with risk associated with just like the individual loans had as single home mortgages. However, CDO’s are by definition a chain in that each CDO is actually only as strong as the weakest mortgages in the bundle but this is a consideration that seemed to escape the notice of most of those so enamored of the use of CDO’s. In most cases the mortgage company retained the responsibility for servicing the loan and actually collecting the money but they no longer owned the loan and were only working for a fee after the mortgage was actually sold. This was also to play into the collapse of the market once it started but I will get back to that a little later.
Naturally, there had to be some way of valuing CDO’s. If you are holding a group of debts and you want to bundle them up into something you can sell, you must first decide what the value of the bundle will be. Who would be best qualified to ascertain the value of such an instrument? Since no one has the necessary prescience to know for certain about such things it fell to the creators of such instruments to value them as well. This is quite a bit like asking a farmer to tell you how much his cow is worth before you pay for it. In actuality the system for valuing CDO’s turned out to be just as fruitful as my example with the cow with the inevitable result that CDO’s were almost universally overvalued from the very beginning. CDO’s are divided into tranches which is a French word for “slice.” The tranches were rated according to the best estimate of the likelihood of the mortgages bundled to go into default. The highest rated tranches (AAA) were of course worth the most money on the market with the lowest rated tranches following accordingly. You will probably be amazed to know that the vast majority of CDO’s were somehow valued as AAA. Unfortunately, these tranches often contained sub-prime and other alternative mortgages that were well understood to be higher risk loans. When the crunch came and loans started to default it suddenly became clear to everyone that no one really knew how much this would devalue the CDO’s they were holding.
Of course there were people who wanted to be sure that the CDO’s they were buying were worth what they were valued at. As my dad used to say, it is virtually impossible that everyone was born yesterday. Credit Default Swaps or CDS’s became widely used to hedge investors bets against CDO’s. Basically the creator of a CDS agrees to stand good for the amount of the investment. In other words, if a CDO is valued at 10 million dollars you could buy a CDS that would hedge your investment by agreeing to pay you the 10 million in case the CDO itself went into default. This was a good idea but a practical impossibility as the upshot was that if a few loans in the bundle went bad there would have to be a determination of how much the total value of the CDO accordingly dropped. Again, this would call for an estimate of the value by the people who created it in the first place. Going back to the farmer analogy this would be the equivalent of the cow suddenly going blind at which point you would have to go back to the farmer who priced it in the first place to decide how much it is worth now that it is blind. The difference in the value of the blind cow and the healthy cow would be paid by the insurer to the holder of the CDS. Unfortunately, the people who originally bundled the CDO’s and sold them were not as honest as your average farmer and most of the CDO’s were in essence for this analogy full of cows with varying degrees of infirmity and potential collapse.
If all of this seems farfetched and ridiculous you are probably not a financial consultant. However, if you recently lost a large portion of your 401K this is the market you were investing in whether you realize it or not. If this were the end of the story we could all shake our heads in wonder and go about our business a little wiser and less financially able but it gets worse. The creator of the CDS who insured the value of the CDO didn’t do this free of charge. The normal matter of business was for the creator of the CDS to be paid a nominal fee for insuring the CDO. As long as the CDO held its value the fee was clear profit for the creator of the CDS. You may have heard of a company called AIG which was one of the companies that the government had to bail out when the market started to slide. As it turns out, they were the biggest insurer of CDO’s in the world at the time. You may or may not be surprised to know that many of the creators of the actual CDS’s were offshore companies under the management of AIG who actually had virtually no funds in reserve to pay for such defaults should they occur. Getting back to our analogy of the cow, if you bought insurance on the cow when you bought him at the farmer’s price and the cow died a couple of months later you would expect that the money you had been paying for insurance was a safeguard against the death of the cow. This would be true as long as the insurance company didn’t go bankrupt before you could file your claim. In our example, this is exactly what happened. As long as they were collecting money these companies were very profitable. When they started having to pay it out, they went under. There are of course rules and regulations for selling insurance in this country. Unfortunately, since the whole derivatives market is outside of any regulatory oversight these rules were not observed in setting up companies to sell CDS’s. Getting back to our analogy; this simply meant that the same farmer who chose the value of the cow before he sold it to you had his brother in law down the road who grows tomatoes set up a company outside the legal strictures of the United States and sell you insurance on the cow. Never mind that there was no money in the company to cover the loss of the cow, the brother in law made money and you got to feel secure in the mistaken belief that you were covered in the event of the untimely death of your new purchase.
All of this led to a market wherein lenders made money off of volume instead of quality. In other words lending institutions soon learned that the real money in the mortgage industry came from bundling mortgages into CDO’s and selling them, not in slowly over a period of 15-30 years making interest off of the loans themselves. The market for CDO’s boomed fantastically and lending institutions felt the pressure to make more loans. It wasn’t that people were suddenly so stupid that they began buying homes they couldn’t afford; it was the fact that lending institutions were aggressively pushing such loans because it didn’t matter if the loan was sound; all that mattered was that the loans could be sold as CDO’s and the money rolled in.
Unfortunately, this is still not the end of the story. The actual dollar amount of CDO’s in the home mortgage industry at the height of the collapse was estimated to be somewhere in the neighborhood of 6 trillion dollars. While this is a formidable number we must remember that this covers all home mortgages in the US, and only a small percentage of them were ever under the threat of foreclosure so we are still talking about numbers that could not possibly crash the whole economy. However, financial consultants being infinitely clever they managed to leverage this market to numbers as high as 350 trillion according to some estimates.
Mortgage CDO’s were taking over the financial markets of the world. The demand was so great that they had to find a way to create more of them than the housing market could possibly support. This was done by creating credit derivatives based upon CDO’s. In other words, a CDO could be created based upon the profit from an existing CDO. It was strictly an artificial construct in that it was not based upon anything but the profit from something that did exist but it could be created and sold on the market and the market was booming so much that people didn’t seem to care that what they were actually buying. It showed a profit as long as the original CDO it was based upon did and everyone was happy. While this sounds more like sleight of hand than finance it is not unusual in the financial markets. I would give you an accurate farmer analogy here but I don’t know of any farmers that would either buy or sell things based upon cows that don’t actually exist; that seems to be a business that requires a much higher degree of education to get into.
The real magic in the creation of a CDO based upon a CDO is that it only takes a fraction of the actual money to create it while it pays the same amount of profit. One hundred to one leveraging was not out of the norm in such markets by the time it went through a couple of such transformations. In other words such a CDO could be created for 50,000 dollars and sell for 5 million dollars as long as the market was increasing and everyone made a profit. Unfortunately, the leveraging worked just the opposite direction when the market started to go down. The CDO would begin losing money at the same rate that the original one it was based upon had with the noticeable exception that it didn’t have any assets at all that could be sold to get your money back. It was basically worth the cost of its creation, assuming of course that you could find someone stupid enough to buy it. Although there seemed to be plenty of people in that category when things were going good almost no one was interested when things started to go the other direction.
Getting back to the cow analogy let’s attempt to follow this logic. The farmer sells you a cow that he has chosen the value of beforehand. Don’t bother to ask how he valued the cow; this is much too complicated for you to understand. Besides if you are worried that you might be buying a blind or sick cow his brother in law who grows tomatoes and runs an offshore insurance company will sell you insurance that covers your investment for a nominal monthly fee. As long as the cattle market goes well your cattle investment goes well and you get statements every month explaining how much money you are making. Everyone is doing wonderfully in this little arrangement, so much so that the farmer soon sells all the cows he has. Since everything is going so well there is still a large demand for cattle, such a large demand that the farmer hits upon the idea of selling you a virtual cow. It isn’t really a cow, it doesn’t have skin, or hooves, or even meat that you could eat if all else fails but he tells you it is just like having a cow in that you get to make the same profit that people who own real cows make and he doesn’t have to go to the trouble of actually feeding or taking care of the cow. Naturally, the virtual cow business is a vast improvement for the farmer since he makes the same amount of money without all the expenses and sweat associated with actually taking care of a cow. It isn’t long before the money invested in virtual cattle far exceeds the number of real cattle.
Unfortunately, for everyone in this cattle business someone decides to actually eat one of the cows one day and discovers that it is too sickly and weak to eat. This immediately brings into question the original value of the cow and it sends a shock wave all the way through the system. Everyone starts to question the value of their own cattle, more especially the people who suddenly realize their virtual cattle aren’t worth the paper they exist on and they certainly aren’t good to eat because that would require they actually existed in the first place. There is a colossal fire sale on cattle of every description but there are no buyers. After all, everyone knows better than to buy more virtual cattle now and the people who made the money off the original sale of cattle have long since taken their money and gotten out of the business. The farmer’s brother in law has gotten out of the insurance business as well since without reserves he knew with the first sign of trouble in the cattle business he was getting ready to be forced pay out everything he had recently made and he doesn’t want to have to go back to growing tomatoes.
Unfortunately, the virtual cattle business was so profitable and so many banks, investment houses, and mutual funds made up of working people’s 401K’s that it will collapse the whole economy if the government allows the chips to fall. The only thing to do is to throw money at the market in the hopes that the cattle market will return and the magical alchemy of virtual cattle starts to go up again because there isn’t enough money in existence to actually pay for the virtual cattle losses if the market stays down. Meanwhile, the inventors of the virtual cattle industry and the virtual insurance industry that it fostered simply have to bide their time and wait for the market to come back. After all, the billions of dollars that just disappeared from the working people’s 401K’s will be enough to allow them to muddle through the next few years.
All of this sounds a little unbelievable. It does explain why both the Secretary of the Treasury and the head of the Federal Reserve were able to convince Bush that something major had to be done. While our GDP hovers around some 14 trillion dollars a year it is hard to see how we can afford a 350 trillion dollar bill to come due. The fact of the matter is that we have not solved this issue to date. There is no government oversight of the system that created this monstrosity of a problem. While some people are making the first attempts at setting one up one of the first orders of business of the new Republican Congress is to defang the new regulations by pulling the funds necessary to set up a regulation industry for the derivatives market. As long as the housing industry goes up this whole byzantine system works in that everyone makes a profit. The farmer who sold virtual cows made a very large profit and he would like to get back into the business but not if the government is going to regulate it. If you want to find out who these farmers are just watch who supports this new effort to cut away at regulation of the industry.
There is a scene in the Matrix where the hero is offered the choice of taking the red pill or the blue pill. One will open his eyes to the world as it exists, the other will allow him to go back to living in ignorant bliss. I don’t think it is an exaggeration to say that we are facing the same choice right now in this country. Either we will open our eyes and take the time to understand what just happened or we will go through it all over again. The problem with living in ignorant bliss is that it doesn’t last forever and we may not be able to print enough money to pay off the next installment when it comes due.
The answer to the riddle is not simple. I have already touched upon it briefly in a previous post but want to delve into the subject in a little more detail now. I personally started looking into this issue several years ago because the numbers simply didn’t add up in my own mind. I have spent quite a bit of time since then studying; poring over books and articles that seemed alternately needlessly complex and ruthlessly simple. I would like to try to break it down into terms that are easy to understand but I am aware that may not be possible. Still, I think it is worth the effort to make the attempt.
The first financial instrument one has to understand to make sense of this mess is a Credit Default Swap or CDS. A CDS is simply a way of selling debt by insuring it. CDS’s were basically invented in the early 1990’s as a means of freeing up capital. The germination for the idea for CDS’s came to fruition when JP Morgan Financial Services was in the process of trying to figure out how to loan money to Exxon in 1994. At the time Exxon was facing punitive damages stemming from the crashing of the Valdez in Alaska. Facing large damages and falling stock prices Exxon was in something of a financial bind at the time. Ordinarily, such situations are handled by high interest loans as banks feel they deserve more profit for making riskier loans. Even though Exxon was a huge conglomerate and showed little possibility of financial collapse as a result of the upcoming high fines they were expecting they didn’t have enough cash on hand to handle paying such fines without selling off something which would have only served to drive their stock prices even lower and make the loans riskier. JP Morgan came up with a rather unique solution to the problem. They loaned Exxon the money, some 5 billion in all. However, JP Morgan didn’t want to tie up all of their capital on one loan that may or may not be the last money Exxon needed to weather the storm after the accident so they were interested in selling off portions of the debt to other investors. The problem with this line of thinking was that there were very few financial institutions able to withstand such a large debt on their books.
JP Morgan executives then sold the risk on the loan to the European Bank of Reconstruction and Development which basically cleared the debt off of their books while they made also made a percentage for brokering the transaction. The whole process started a chain reaction of ideas within JP Morgan and the rest of the financial institutions around the world as they studied the feasibility of making loans while at the same time avoiding holding the debts on their books. It seemed eminently profitable to find a way to broker deals for such loans while at the same time avoiding holding long term debts on their books which unavoidably cut into the capital they had available to make the loans to begin with. This is much the same fascination that the middle ages had for alchemy. Just substitute the term “debt” for iron and “asset” for gold and you have the general idea. What could be better to a financial institution than the ability to instantaneously turn a debt into an asset?
It wasn’t long after this that another artificial construct along the same lines began to come into favor in the mortgage industry. Collaterized Debt Obligations are structured credit products that were supposed to increase the availability of credit by leveraging the amount of money available for such loans. In short, a CDO in the context of this discussion is a bundle of home mortgages that is sold as an asset. If you think this seems a little like magic you are not very far from the truth. Lending institutions have always been limited to loaning out a factor of the money they have in reserve (their depositor’s savings) in case the loans go into default. It is really a matter of common business sense that any financial institution can only lend out a finite amount of money because it has to hold a small percentage of these loans in the form of capital to support such loans in the event of defaults. Obviously, there are rules and regulations to this effect and the Federal Deposit Insurance Corporation that guarantees depositor’s money is officially responsible for enforcing such restrictions in this country.
With the advent of CDO’s, lending institutions could bundle up groups of mortgages and sell them as assets to insurance companies, pension funds, hedge funds, and investment banks. While the lending institution thereby only made a percentage of the total value of the loan, it was an instantaneous profit while it simultaneously cleared the loan from their books. This freed up their committed reserves so that they could then lend the same reserve out again and again. It is worth remembering that a mortgage based CDO is actually a bundle of debts. While this bundle of debts certainly has a marketable value it is still a bundle of debts with risk associated with just like the individual loans had as single home mortgages. However, CDO’s are by definition a chain in that each CDO is actually only as strong as the weakest mortgages in the bundle but this is a consideration that seemed to escape the notice of most of those so enamored of the use of CDO’s. In most cases the mortgage company retained the responsibility for servicing the loan and actually collecting the money but they no longer owned the loan and were only working for a fee after the mortgage was actually sold. This was also to play into the collapse of the market once it started but I will get back to that a little later.
Naturally, there had to be some way of valuing CDO’s. If you are holding a group of debts and you want to bundle them up into something you can sell, you must first decide what the value of the bundle will be. Who would be best qualified to ascertain the value of such an instrument? Since no one has the necessary prescience to know for certain about such things it fell to the creators of such instruments to value them as well. This is quite a bit like asking a farmer to tell you how much his cow is worth before you pay for it. In actuality the system for valuing CDO’s turned out to be just as fruitful as my example with the cow with the inevitable result that CDO’s were almost universally overvalued from the very beginning. CDO’s are divided into tranches which is a French word for “slice.” The tranches were rated according to the best estimate of the likelihood of the mortgages bundled to go into default. The highest rated tranches (AAA) were of course worth the most money on the market with the lowest rated tranches following accordingly. You will probably be amazed to know that the vast majority of CDO’s were somehow valued as AAA. Unfortunately, these tranches often contained sub-prime and other alternative mortgages that were well understood to be higher risk loans. When the crunch came and loans started to default it suddenly became clear to everyone that no one really knew how much this would devalue the CDO’s they were holding.
Of course there were people who wanted to be sure that the CDO’s they were buying were worth what they were valued at. As my dad used to say, it is virtually impossible that everyone was born yesterday. Credit Default Swaps or CDS’s became widely used to hedge investors bets against CDO’s. Basically the creator of a CDS agrees to stand good for the amount of the investment. In other words, if a CDO is valued at 10 million dollars you could buy a CDS that would hedge your investment by agreeing to pay you the 10 million in case the CDO itself went into default. This was a good idea but a practical impossibility as the upshot was that if a few loans in the bundle went bad there would have to be a determination of how much the total value of the CDO accordingly dropped. Again, this would call for an estimate of the value by the people who created it in the first place. Going back to the farmer analogy this would be the equivalent of the cow suddenly going blind at which point you would have to go back to the farmer who priced it in the first place to decide how much it is worth now that it is blind. The difference in the value of the blind cow and the healthy cow would be paid by the insurer to the holder of the CDS. Unfortunately, the people who originally bundled the CDO’s and sold them were not as honest as your average farmer and most of the CDO’s were in essence for this analogy full of cows with varying degrees of infirmity and potential collapse.
If all of this seems farfetched and ridiculous you are probably not a financial consultant. However, if you recently lost a large portion of your 401K this is the market you were investing in whether you realize it or not. If this were the end of the story we could all shake our heads in wonder and go about our business a little wiser and less financially able but it gets worse. The creator of the CDS who insured the value of the CDO didn’t do this free of charge. The normal matter of business was for the creator of the CDS to be paid a nominal fee for insuring the CDO. As long as the CDO held its value the fee was clear profit for the creator of the CDS. You may have heard of a company called AIG which was one of the companies that the government had to bail out when the market started to slide. As it turns out, they were the biggest insurer of CDO’s in the world at the time. You may or may not be surprised to know that many of the creators of the actual CDS’s were offshore companies under the management of AIG who actually had virtually no funds in reserve to pay for such defaults should they occur. Getting back to our analogy of the cow, if you bought insurance on the cow when you bought him at the farmer’s price and the cow died a couple of months later you would expect that the money you had been paying for insurance was a safeguard against the death of the cow. This would be true as long as the insurance company didn’t go bankrupt before you could file your claim. In our example, this is exactly what happened. As long as they were collecting money these companies were very profitable. When they started having to pay it out, they went under. There are of course rules and regulations for selling insurance in this country. Unfortunately, since the whole derivatives market is outside of any regulatory oversight these rules were not observed in setting up companies to sell CDS’s. Getting back to our analogy; this simply meant that the same farmer who chose the value of the cow before he sold it to you had his brother in law down the road who grows tomatoes set up a company outside the legal strictures of the United States and sell you insurance on the cow. Never mind that there was no money in the company to cover the loss of the cow, the brother in law made money and you got to feel secure in the mistaken belief that you were covered in the event of the untimely death of your new purchase.
All of this led to a market wherein lenders made money off of volume instead of quality. In other words lending institutions soon learned that the real money in the mortgage industry came from bundling mortgages into CDO’s and selling them, not in slowly over a period of 15-30 years making interest off of the loans themselves. The market for CDO’s boomed fantastically and lending institutions felt the pressure to make more loans. It wasn’t that people were suddenly so stupid that they began buying homes they couldn’t afford; it was the fact that lending institutions were aggressively pushing such loans because it didn’t matter if the loan was sound; all that mattered was that the loans could be sold as CDO’s and the money rolled in.
Unfortunately, this is still not the end of the story. The actual dollar amount of CDO’s in the home mortgage industry at the height of the collapse was estimated to be somewhere in the neighborhood of 6 trillion dollars. While this is a formidable number we must remember that this covers all home mortgages in the US, and only a small percentage of them were ever under the threat of foreclosure so we are still talking about numbers that could not possibly crash the whole economy. However, financial consultants being infinitely clever they managed to leverage this market to numbers as high as 350 trillion according to some estimates.
Mortgage CDO’s were taking over the financial markets of the world. The demand was so great that they had to find a way to create more of them than the housing market could possibly support. This was done by creating credit derivatives based upon CDO’s. In other words, a CDO could be created based upon the profit from an existing CDO. It was strictly an artificial construct in that it was not based upon anything but the profit from something that did exist but it could be created and sold on the market and the market was booming so much that people didn’t seem to care that what they were actually buying. It showed a profit as long as the original CDO it was based upon did and everyone was happy. While this sounds more like sleight of hand than finance it is not unusual in the financial markets. I would give you an accurate farmer analogy here but I don’t know of any farmers that would either buy or sell things based upon cows that don’t actually exist; that seems to be a business that requires a much higher degree of education to get into.
The real magic in the creation of a CDO based upon a CDO is that it only takes a fraction of the actual money to create it while it pays the same amount of profit. One hundred to one leveraging was not out of the norm in such markets by the time it went through a couple of such transformations. In other words such a CDO could be created for 50,000 dollars and sell for 5 million dollars as long as the market was increasing and everyone made a profit. Unfortunately, the leveraging worked just the opposite direction when the market started to go down. The CDO would begin losing money at the same rate that the original one it was based upon had with the noticeable exception that it didn’t have any assets at all that could be sold to get your money back. It was basically worth the cost of its creation, assuming of course that you could find someone stupid enough to buy it. Although there seemed to be plenty of people in that category when things were going good almost no one was interested when things started to go the other direction.
Getting back to the cow analogy let’s attempt to follow this logic. The farmer sells you a cow that he has chosen the value of beforehand. Don’t bother to ask how he valued the cow; this is much too complicated for you to understand. Besides if you are worried that you might be buying a blind or sick cow his brother in law who grows tomatoes and runs an offshore insurance company will sell you insurance that covers your investment for a nominal monthly fee. As long as the cattle market goes well your cattle investment goes well and you get statements every month explaining how much money you are making. Everyone is doing wonderfully in this little arrangement, so much so that the farmer soon sells all the cows he has. Since everything is going so well there is still a large demand for cattle, such a large demand that the farmer hits upon the idea of selling you a virtual cow. It isn’t really a cow, it doesn’t have skin, or hooves, or even meat that you could eat if all else fails but he tells you it is just like having a cow in that you get to make the same profit that people who own real cows make and he doesn’t have to go to the trouble of actually feeding or taking care of the cow. Naturally, the virtual cow business is a vast improvement for the farmer since he makes the same amount of money without all the expenses and sweat associated with actually taking care of a cow. It isn’t long before the money invested in virtual cattle far exceeds the number of real cattle.
Unfortunately, for everyone in this cattle business someone decides to actually eat one of the cows one day and discovers that it is too sickly and weak to eat. This immediately brings into question the original value of the cow and it sends a shock wave all the way through the system. Everyone starts to question the value of their own cattle, more especially the people who suddenly realize their virtual cattle aren’t worth the paper they exist on and they certainly aren’t good to eat because that would require they actually existed in the first place. There is a colossal fire sale on cattle of every description but there are no buyers. After all, everyone knows better than to buy more virtual cattle now and the people who made the money off the original sale of cattle have long since taken their money and gotten out of the business. The farmer’s brother in law has gotten out of the insurance business as well since without reserves he knew with the first sign of trouble in the cattle business he was getting ready to be forced pay out everything he had recently made and he doesn’t want to have to go back to growing tomatoes.
Unfortunately, the virtual cattle business was so profitable and so many banks, investment houses, and mutual funds made up of working people’s 401K’s that it will collapse the whole economy if the government allows the chips to fall. The only thing to do is to throw money at the market in the hopes that the cattle market will return and the magical alchemy of virtual cattle starts to go up again because there isn’t enough money in existence to actually pay for the virtual cattle losses if the market stays down. Meanwhile, the inventors of the virtual cattle industry and the virtual insurance industry that it fostered simply have to bide their time and wait for the market to come back. After all, the billions of dollars that just disappeared from the working people’s 401K’s will be enough to allow them to muddle through the next few years.
All of this sounds a little unbelievable. It does explain why both the Secretary of the Treasury and the head of the Federal Reserve were able to convince Bush that something major had to be done. While our GDP hovers around some 14 trillion dollars a year it is hard to see how we can afford a 350 trillion dollar bill to come due. The fact of the matter is that we have not solved this issue to date. There is no government oversight of the system that created this monstrosity of a problem. While some people are making the first attempts at setting one up one of the first orders of business of the new Republican Congress is to defang the new regulations by pulling the funds necessary to set up a regulation industry for the derivatives market. As long as the housing industry goes up this whole byzantine system works in that everyone makes a profit. The farmer who sold virtual cows made a very large profit and he would like to get back into the business but not if the government is going to regulate it. If you want to find out who these farmers are just watch who supports this new effort to cut away at regulation of the industry.
There is a scene in the Matrix where the hero is offered the choice of taking the red pill or the blue pill. One will open his eyes to the world as it exists, the other will allow him to go back to living in ignorant bliss. I don’t think it is an exaggeration to say that we are facing the same choice right now in this country. Either we will open our eyes and take the time to understand what just happened or we will go through it all over again. The problem with living in ignorant bliss is that it doesn’t last forever and we may not be able to print enough money to pay off the next installment when it comes due.
Monday, November 15, 2010
Economic Collapse Part I
What happened to the economy in 2008? Obviously, we went into a recession or maybe even a depression but what happened to cause this to happen? Lots of people want to know the answer to that but I am afraid that for the most part we are listening to the wrong sources to figure it out. What we really need to do is understand what kind of economy we actually have in the US today to be able to understand what just went wrong with it. Unfortunately, I don’t see a lot of people taking this approach as it is always easier to continue a bad policy than to understand what is wrong with it in the first place.
Maybe we should start with some of the currently accepted ideas as to what went wrong with the economy. If you listen to Rush Limbaugh or Sean Hannity or any of their carefully cloned copies currently filling the talk radio airwaves you will hear that government is at fault. In their view, the government began to interfere with the free market and this caused a lot of loans to be made that were not secure loans. When these loans inevitably went into default, the market began to collapse and voila; we have a recession on our hands. Big government, in its infinite ignorance of the free market, basically caused the whole thing. To be even more explicit, liberal politicians in their effort to take care of their entitled voter base began to force the free market to loan money to people who couldn’t afford to pay it back.
If this sounds familiar, it is because we have heard it before. Ronald Reagan used similar logic to get himself elected in 1980. We had a recession during that time too. Jimmy Carter, the incumbent president went on TV and began asking Americans to cut back, to conserve, to consider the possibility that we might all have to do things differently to continue to lead the free world in economic growth. Self sacrifice and a calling to a greater good were his solution to the problems we were facing at the time. Reagan took the opposite tact and began excoriating government as the source of the problem. In Reagan’s view it was the government and its entitlements programs to those undeserving that were dragging the economy down. Welfare queens who lived better than the average working man were the topic he continually wanted to dote upon whether it actually had anything to do with the problems we were facing or not.
Reagan knew what we really needed. A scapegoat to blame all our problems on; especially one that would resonate so thoroughly with working class Americans and he found it in the welfare queens and the liberals in government who fostered them. Unfortunately, this recipe for fixing the problem didn’t work then and it won’t work this time either. In point of fact, the government might have been part of the problem in that it has blindly supported the corporate entities that have been feeding it money for the last half of the 20th century but that is like blaming the cow for giving bad milk when you feed it onions all day.
Let’s take a look at the actual numbers of what was going on in 2008 when the government publicly admitted that it was going to have to bail out the private banking concerns in this country. On September 18, 2008 Ben Bernanke (head of the Federal Reserve) and Treasury Secretary Henry Paulsen met with key Congressional legislators with the message that they needed 700 Billion dollars to avoid a financial catastrophe. This wasn’t some cry in the wilderness from a lunatic fringe; this was the head of the Federal Reserve and the head of the US Treasury telling US congressmen that they had to do something quick. In Bernanke’s words,
“If we don’t do this, we may not have an economy on Monday.”
In order to understand the magnitude of this statement it is necessary to look back a little bit. The George W. Bush administration, the Bill Clinton administration, the George H. W. Bush administration, and the Ronald Reagan administration have been in power in Washington since 1980. There is little doubt that they have been the most business friendly, corporate sponsored administrations in the history of this country. With the exception of the first term of the Clinton presidency we had seen 28 years of pro business government without respite. They have gradually dismantled or defanged every financial regulatory agency, every economic control that was put in place after the Great Depression. These agencies and laws were put in place after the Great Depression for the express reason that some very bright men took a look at what happened then and decided they needed regulations to keep from having a repeat performance. Not surprisingly, we are now getting that repeat performance and for many of the same reasons that the last collapse happened.
The George W. Bush administration was arguably the friendliest to corporate interests and de-regulation of the industry. Imagine what it took to convince a president extraordinarily concerned with his public image and how he would be viewed by history to completely reverse his field on how free markets are supposed to work in his last 4 months in office. I would like to have been a fly on the wall in the meeting when Bernanke and Paulsen proposed to him that in order to stave off total economic collapse; he was going to have to nationalize the US banking system by doing a government bailout. I wonder what it took to convince him that his whole laissez-faire approach to economics was wrong; that he was going to have to socialize the US financial system to avoid a worldwide economic collapse. Everyone seems to miss that this occurred; that a notoriously stubborn and self serving US President who had built his whole career around the idea that we need less government suddenly decided the government was the only solution. What did they actually show him in that meeting?
Let’s look at some numbers to see if the current ideas about home mortgage defaults explain the problem. In September of 2008 there were some 760,000 homes in danger of foreclosure according to data released by the US Foreclosure Market report. While this is a high number it doesn’t explain the collapse. In 2008 the average home mortgage total value was 167,000 dollars. If you multiply 760,000 by 167,000 which is the worst possible scenario because it assumes that each and every house in danger of foreclosure instantly becomes a total loss you come up with a little less than 127 billion dollars. Keep in mind that this is the worst possible case in that most home foreclosures actually result in much lower losses after all the paperwork is done and the lawyers are paid. According to most estimates I have found the highest average is quote by Freddie Mac officials as 60,000 dollars. Using this number which is actually quite a bit higher than most estimates and multiplying it by 760,000 we come up with somewhat less than 46 billion dollars. In other words, if worse came to worse and every single home that was in danger of foreclosure in September of 2008 actually occurred all at once the industry would be looking at a 45.6 billion dollar loss. Remember, this is the worst case scenario and assumes that all these homes were foreclosed upon at once. Where did the 700 Billion dollar numbers that Paulsen and Bernanke were talking about come from? Clearly, there is something else going on that we aren’t discussing on a public level and I will get back to that in a later post but for now I just wanted to point out that if the foreclosure market was the problem we could have completely solved that with a 46 billion dollar injection into the market and I heard no one in power making that suggestion.
In my next post on this subject I will begin to explore the Community Reinvestment Act and how it supposedly led to the collapse of the housing bubble.
Maybe we should start with some of the currently accepted ideas as to what went wrong with the economy. If you listen to Rush Limbaugh or Sean Hannity or any of their carefully cloned copies currently filling the talk radio airwaves you will hear that government is at fault. In their view, the government began to interfere with the free market and this caused a lot of loans to be made that were not secure loans. When these loans inevitably went into default, the market began to collapse and voila; we have a recession on our hands. Big government, in its infinite ignorance of the free market, basically caused the whole thing. To be even more explicit, liberal politicians in their effort to take care of their entitled voter base began to force the free market to loan money to people who couldn’t afford to pay it back.
If this sounds familiar, it is because we have heard it before. Ronald Reagan used similar logic to get himself elected in 1980. We had a recession during that time too. Jimmy Carter, the incumbent president went on TV and began asking Americans to cut back, to conserve, to consider the possibility that we might all have to do things differently to continue to lead the free world in economic growth. Self sacrifice and a calling to a greater good were his solution to the problems we were facing at the time. Reagan took the opposite tact and began excoriating government as the source of the problem. In Reagan’s view it was the government and its entitlements programs to those undeserving that were dragging the economy down. Welfare queens who lived better than the average working man were the topic he continually wanted to dote upon whether it actually had anything to do with the problems we were facing or not.
Reagan knew what we really needed. A scapegoat to blame all our problems on; especially one that would resonate so thoroughly with working class Americans and he found it in the welfare queens and the liberals in government who fostered them. Unfortunately, this recipe for fixing the problem didn’t work then and it won’t work this time either. In point of fact, the government might have been part of the problem in that it has blindly supported the corporate entities that have been feeding it money for the last half of the 20th century but that is like blaming the cow for giving bad milk when you feed it onions all day.
Let’s take a look at the actual numbers of what was going on in 2008 when the government publicly admitted that it was going to have to bail out the private banking concerns in this country. On September 18, 2008 Ben Bernanke (head of the Federal Reserve) and Treasury Secretary Henry Paulsen met with key Congressional legislators with the message that they needed 700 Billion dollars to avoid a financial catastrophe. This wasn’t some cry in the wilderness from a lunatic fringe; this was the head of the Federal Reserve and the head of the US Treasury telling US congressmen that they had to do something quick. In Bernanke’s words,
“If we don’t do this, we may not have an economy on Monday.”
In order to understand the magnitude of this statement it is necessary to look back a little bit. The George W. Bush administration, the Bill Clinton administration, the George H. W. Bush administration, and the Ronald Reagan administration have been in power in Washington since 1980. There is little doubt that they have been the most business friendly, corporate sponsored administrations in the history of this country. With the exception of the first term of the Clinton presidency we had seen 28 years of pro business government without respite. They have gradually dismantled or defanged every financial regulatory agency, every economic control that was put in place after the Great Depression. These agencies and laws were put in place after the Great Depression for the express reason that some very bright men took a look at what happened then and decided they needed regulations to keep from having a repeat performance. Not surprisingly, we are now getting that repeat performance and for many of the same reasons that the last collapse happened.
The George W. Bush administration was arguably the friendliest to corporate interests and de-regulation of the industry. Imagine what it took to convince a president extraordinarily concerned with his public image and how he would be viewed by history to completely reverse his field on how free markets are supposed to work in his last 4 months in office. I would like to have been a fly on the wall in the meeting when Bernanke and Paulsen proposed to him that in order to stave off total economic collapse; he was going to have to nationalize the US banking system by doing a government bailout. I wonder what it took to convince him that his whole laissez-faire approach to economics was wrong; that he was going to have to socialize the US financial system to avoid a worldwide economic collapse. Everyone seems to miss that this occurred; that a notoriously stubborn and self serving US President who had built his whole career around the idea that we need less government suddenly decided the government was the only solution. What did they actually show him in that meeting?
Let’s look at some numbers to see if the current ideas about home mortgage defaults explain the problem. In September of 2008 there were some 760,000 homes in danger of foreclosure according to data released by the US Foreclosure Market report. While this is a high number it doesn’t explain the collapse. In 2008 the average home mortgage total value was 167,000 dollars. If you multiply 760,000 by 167,000 which is the worst possible scenario because it assumes that each and every house in danger of foreclosure instantly becomes a total loss you come up with a little less than 127 billion dollars. Keep in mind that this is the worst possible case in that most home foreclosures actually result in much lower losses after all the paperwork is done and the lawyers are paid. According to most estimates I have found the highest average is quote by Freddie Mac officials as 60,000 dollars. Using this number which is actually quite a bit higher than most estimates and multiplying it by 760,000 we come up with somewhat less than 46 billion dollars. In other words, if worse came to worse and every single home that was in danger of foreclosure in September of 2008 actually occurred all at once the industry would be looking at a 45.6 billion dollar loss. Remember, this is the worst case scenario and assumes that all these homes were foreclosed upon at once. Where did the 700 Billion dollar numbers that Paulsen and Bernanke were talking about come from? Clearly, there is something else going on that we aren’t discussing on a public level and I will get back to that in a later post but for now I just wanted to point out that if the foreclosure market was the problem we could have completely solved that with a 46 billion dollar injection into the market and I heard no one in power making that suggestion.
In my next post on this subject I will begin to explore the Community Reinvestment Act and how it supposedly led to the collapse of the housing bubble.
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