Saving our economy

It’s a beautiful day outside, but somewhere events are unfolding that may destroy our way of life.  What happened and what should we do?

Ideologues will tell you that we should not bail out the rich, and I agree.  However, as the operator of a business with a national sales base, I can report firsthand that consumer sentiment has already dropped (you know that yourself, but everyone else has cut back, too), which means that sales are falling precipitously everywhere as we all hold onto our money, and the great machine of commerce is grinding to a halt.  The investment markets are a reflection of what has already happened in the malls.  Politicians are not merely trying to scare you: they are frightened themselves.  The phrase repeated on Capitol Hill and in the media is “we are in uncharted waters.”

The economy runs on confidence, which is what money really measures.  We have confidence that the products we buy will perform as advertised, that we are working for useful enterprises with promising futures, that we will keep our jobs and be able to retire some day, and, generally, that tomorrow will be better than today.  So when we stop believing in ourselves and our everyday pursuits, everything stops.  We stop transacting commerce, and, very quickly, lots and lots of jobs are lost.

Unemployment reached almost 25% in the 1930s.  It will happen again unless we re-start the flow of commerce soon.

If you want to know how we got into this situation, I have published a note below from a friend of a friend who writes cogently about the financial structures involved.  Here are a few other observations:

  • This is not a “sub prime mortgage” problem.  Unfortunately, the sub-text of our nation’s financial melt-down contains a core belief that some bad people spent more than they should have and they’re taking down the rest of the world, too.  There are about 1.1 million foreclosures in the U.S. and the median house price is about $200,000, so you could buy every last foreclosure for about $200 billion.  Of course, you wouldn’t have to buy the whole house to prevent this kind of disaster, but that’s about the cost of owning every last house outright, so something else is going on here.
  • What real mortgage problems existed were encouraged by the bankers and their lobbyists who dropped minimum down payments and sensible loan regulations, which inflated bids for houses and created larger and less bearable mortgages.  In The Great Crash, 1929, John Kenneth Galbraith marvels that Florida real estate was purchased in the 1920’s for as little as 10% down;  in 2005, the median down payment on a U.S. home was 2%;  43% of homes were bought for “no money down.”
  • It took real imagination and the best minds of a generation to leverage some bad housing loans into a trillion dollar problem.  Business math is relatively simple, but the financial industry made it complex and sold the idea that risk could be scientifically accounted and pushed to the very edges of existence.  Financiers peddled the emperor’s new clothes: they pretended they knew something you could not understand and that, as the motive force of the invisible hand, they delivered a magic value to the economy for which they deserved out-sized rewards.  The new math was sold, re-packaged and re-sold until the world derivative market reached nine times the world’s gross domestic product – about $596 trillion.
  • It was a great scam while it lasted.  In 2006, Goldman Sachs paid out $16.5 billion in bonus compensation, an average of roughly $623,418 per employee. The average managing director’s total compensation on Wall Street that year was $2 million.  In 2007, Goldman Sachs paid out about $20 billion to its brainy tailors. 
  • All this manipulation further concentrated wealth in the U.S., and at the same time siphoned off intelligence that we could have used to create, instead of redistribute, wealth.  We create real wealth when we farm, mine, manufacture or improve a process.  Real wealth improves our lives.  Finance for finance’s sake is a game played to benefit those running the game.  When finance deviates from assisting in the creation of real wealth, it instead concentrates existing wealth.  During the last 20 years, the financial industry grew from 10% to 40% of corporate profits while its share of stock market value grew from 6 to 19%.  The industry employs only 5% of private sector jobs.

So do we let our house burn down because the firemen stole the safe?  Tempting, but that’s a worse outcome.  Here are a few suggestions:

  • Get money moving again.
  • Approve a plan that can be monitored and modified by Congress as it rolls out.
  • If we’re going to use public money, take shares in their companies.  Bankers call this a “cram down,” and they would be cramming you down today if your company had performed half as poorly as theirs.
  • Announce aggressive incentives for alternative energy investment.  A big part of our problem is that our way of life is built on cheap energy, which we no longer control.  We need to take back control of our energy supplies so that we can stop exporting our wealth to people who hate us.
  • Invest again in companies that produce a better way of life.  Americans are entrepreneurial and innovative.  Get back to creating real wealth.
  • Let small businesses raise money again.  After Enron, the protections that Congress put in place effectively prevented the middle class from investing in (and benefiting from) start-ups, and handed control over any promising business to the financial class.  Given the oppressive requirements of the Sarbannes-Oxley act, a company today must reach $100 million in sales to justify a public offering in the U.S.  This has reduced capital available for the innovative reinvention of the U.S. economy, which has always been carried out by small companies, not large ones.
  • With so much new money coming into the system, we will endure inflation, but, if we get back to creating real value, we will be more productive and will be able to moderate inflation.  The alternative – deflation and joblessness – is far worse.

Whatever plan Congress approves will be the biggest spending program in our history.  It will be bigger than the social security administration and bigger than the the military.  We should be angry about this.  We should investigate the bad guys and, in an ironic twist, take their vacation homes.  Most important, though, we need to put out the fire and get back to building a better way of life, which is what most Americans do best.

———————–

The 2008 financial crisis
 
The problem we find ourselves in today is frightening for the financial sector of our economy, not for the overall economy. We remain the dominant country in the world, our GDP is the largest, our businesses remain successful, and the dollar is still considered the basic currency of the world. As long as we are able to avoid the worst case scenario the problems we are facing should have little, if any, impact on most ordinary people’s daily lives.
 
However, if problems in the financial sector are not resolved, it could have deep reaching effects on our society. In order for businesses to expand and to meet the normal fluctuations of commerce they require money to operate and to invest in plant and equipment. In other words, money is the oil that keeps the engine of our economy going. If the commercial banks and the investment banks find that their financial situations become desperate, they may need to sell assets and/or restrict lending to ordinary commercial businesses in order to meet regulatory and other requirements.
 
How we got there
So, what has caused this “financial crisis?” The answer is neither simple nor quick. The origins were in the 1980’s when the banks discovered the concept of derivatives. These were not loans per se, they were financial transactions designed to shift certain risks in financings from one party to another. The large international banks and the more sophisticated investment banks in London and New York quickly embraced the product. They first achieved popularity in currency swaps where one party had revenues in one currency and obligations to pay in another. In order to alleviate the risk of changes in the exchange rate between the two, banks would agree to guarantee the value of one of the currencies for some period of time. Because they traded in a great many currencies the banks could “lay off’ this risk by entering into other swaps to cover their exposure. Their proponents characterized these as “zero sum deals,” in other words when one party lost, the other party gained so the total remained the same. Over time, this field became more and more dominated by mathematical wizards, not financial people. These people became known as “quants” because of their reliance on quantitative analysis.
 
The quants were pushed by their bosses with financial backgrounds to create ever-more complicated and larger transactions, in order to increase the bank’s fees. These deals got so complicated and involved such esoteric equations, that the senior management of the banks had almost no knowledge of what the derivatives actually concerned, what the risks were, and even how much exposure they represented to the bank involved. The managers were, however, very aware of the amount of fees generated. Another reason management liked the product so much was that it was not regulated by the banking authorities. Neither accountants nor the regulators were able to understand these, let alone place any realistic value on them. So, these were almost free money to banks, the funds involved were not required to meet regulatory requirements and were not required to be disclosed in financial statements.
 
The idea of transferring the risk of any financial transaction spread throughout the industry and began to take many different forms. Some of the more dubious examples involved Enron offering weather insurance and the failure of Long Term Capital Management. However, these setbacks did not thwart derivatives, quite the contrary. As derivatives continued to become more widespread a new investment vehicle was created, the Hedge Fund.
 
These funds are usually created by people who have established successful track records as quants and are now prepared to step out on their own. They approach very rich individuals (at least several million dollars to invest) or financial institutions to give them money. They base their investment decisions on a variety of quantitative analyses that are often counter to the accepted wisdom. They invest this money in unusual transactions, they might invest a new financial product that the market has not discovered yet, and they are always willing to take larger than normal risks in order to earn higher returns.
 
Because their actions are usually counter to others they require almost complete secrecy in all their dealings. So, if you invest $10 million in a hedge fund it is not unusual that you would have no idea whatsoever where your money is invested. Of course, there is a reason hedge fund managers can do this. They often earn extraordinarily high returns, 25-75+ % per year. This is achieved not only by their investing but also by their use of leverage−they borrow large amounts of money to increase the amounts they have to invest. They hope to pay back the loans out of their profits. If they don’t have any profits, the leverage works against them and they may be forced to pay back the loans out of their investor’s principal.
 
Because they are entirely unregulated hedge funds can charge whatever they want for their services. The industry standard is roughly 2-3% annual management fee and up to 25% of all profits earned during the year. The hedge fund industry has a very active lobbying effort in Washington and is a generous donor to many political campaigns. For some reason, Congress has allowed hedge fund managers to treat the 25% of profits earned as long term capital gains, not ordinary income. When the sheer size of many of the funds is included with this unique tax break it is not surprising that the hedge funds have created a whole new class of billionaires in the United States and elsewhere.
 
The large international commercial banks were very aware of the high returns being created by the hedge funds and investment banks. But, they were highly regulated by national and internationals standards. They couldn’t make the kind of investments or take the kind of risks of the other institutions. They had to keep their balance sheets in order and they had to meet strict capital requirements. That is, until they discovered subsidiaries and structured investment vehicles, a shadow banking system. These subs and the products they traded in did not have to be included on their balance sheets nor did they have to be fully disclosed to the regulators. They were a way for the international commercial banks to play the same game as the investment banks and the hedge funds. Globalization had long been a fact of life in the financial markets and now it was in its heyday. The investment bankers were only too happy to sell their products to the new players. Once the commercial banks got into the market, they began to put together similar products of their own, mainly to sell to one another.
 
In the period 2000 – 2006 the financial markets were dominated by several major motivators; the first was an increasing emphasis on ever greater profits, the second was a movement towards those parts of the markets where government regulation either did not exist or was not effective, the third was the belief that the risks of many financial transactions could be significantly reduced by the careful structuring of them, and finally the belief in the complete freedom of the capital markets by the current U.S. administration.
 
When all these came together we had what amounts to an international free for all. Local markets were no longer important, they were just too small. Any financial products that didn’t have the capacity to grow into the hundreds of billions, even trillions, weren’t considered worth anybody’s time. New products were developed and marketed successfully−whose only rationale was the quant’s support of them−with little or no thought given to the underlying financial realities. Profits and individual incomes grew into such obscene amounts they overshadowed any other considerations. The March 22 issue of the Economist Magazine pointed out that the financial services sector of the U.S. economy represented 40% of total corporate profits earned in 2006, while it represented just 5% of all private sector jobs. By contrast, financial services earned 10% of total profits in the early 1980’s. And, because of all of the above, no one bothered to look at the ultimate risk; they all liked the emperor’s new clothes too much.
 
What is today’s financial crisis?
Actually it’s not one, but three, financial crisis’s we find ourselves in. The first is the sub-prime mortgage crisis. The second is the Structured Investment Vehicle (SIV) crisis. And the third is the Credit Default Insurance crisis. These are all the result of recently created financial products. Although they are different, they all affect the financial markets and they appear to share much of the same impacts. Most simplistically, if they continue to go wrong and are not solved in the not too distant future, they could greatly reduce the amount of credit available to the world’s businesses, they could seriously weaken many of the world’s largest financial institutions, and, in the worst case, they could make confidence in most of the world’s financial system crumble.
 
Subprime Mortgages
In 2004-5 the U.S. Government wanted to make the dream of owning a home available to more people. House prices had increased dramatically, freezing many prospective purchasers out of the market. In order to implement their desire, the government sent out a signal to mortgage lenders that they might want to relax their borrowing standards and the regulators would look the other way.
 
The mortgage brokers, mortgage companies, banks, and other lenders enthusiastically complied. Down payment requirements were reduced to zero in many cases, income requirements were consistently reduced, and assertions made on mortgage applications were often not checked. Because of the long term increase in home prices the lenders thought there was little risk in such irresponsible actions.
 
Then, as the marker overheated, people who were speculators, not income-challenged potential borrowers, also took advantage of the easier terms being offered. Applicants of all income strata felt less restrained by logic and the truth, telling the lenders whatever the applicants thought they wanted to hear. The mortgage brokers and lenders began offering products such as adjustable rate mortgages (ARM’s) in order to entice people to commit to ever larger obligations, even if many of them could not reasonably afford them. Unprincipled brokers and others used misleading and often illegal incentives to get people to commit to mortgages.
 
When the real estate bubble burst and home prices no longer increased – and actually started to decline, many participants found themselves stranded. The speculators, who had overcommitted to houses, condominiums, etc. found themselves with mortgages on properties that they could not sell or even rent, while the demand for mortgage payments continued. The option of many of these was to walk away from their obligations or declare bankruptcy. Owners of rental properties who could not pay their mortgages walked away, leaving their renters, with no one to pay rent to, out in the street. Those homeowners who either overcommitted to mortgage obligations or found that they could not pay the higher monthly payments on their ARM’s, tried desperately to contact the mortgage holder to renegotiate their payments or  sell their homes at greatly reduced prices.
 
The impacts, which are currently ongoing, can already be seen throughout the country. New home construction has slowed dramatically, sales of both new and existing homes has decreased, defaults and bankruptcies have greatly increased, in many areas where defaults are widespread, the neighborhoods themselves have deteriorated  to such an extent that past home values have disappeared almost entirely. Many unfortunate people who would have sold their homes for a loss are finding that they can’t attract any buyers at any price.
 
In the past the bursting of such a speculative bubble would have serious and painful effects but it would not have been a crisis of this magnitude. The speculators would have suffered, having to sell their properties at a loss. Landlords would have been able to negotiate with their bankers and tenants to come up with some sort of financial arrangements that kept them going. Many mortgage holders might have been able to convince their bankers to give them payment options that were lower in return for increased or longer mortgages. Or, in the worst case, might have been forced to sell their homes at the loss of some or all of their equity. But almost all cases assumed the ability to sell one’s real estate−at some price and at some time. Although the banks would have suffered during this period most of them would have still had money to lend. These funds are the grease that allowed the market to keep operating, even if at a lower level.
 
This does not appear to be the case today. The number of sub-prime mortgages is turning out to be much higher than anyone imagined even last year. Banks and mortgage companies have reacted to the sub-prime mess by dramatically increasing lending standards, often refusing even good credit borrowers. This, in turn, has led to a real estate market where many properties can’t be sold, at any price. Borrowers who turn to their bankers are often told, “Sorry, I can’t help you. We sold your mortgage, with others, to a securities firm and I have no idea who owns your mortgage now.” The banks themselves often face severe cutbacks in lending simply to comply with the capital requirements of federal regulators.
 
What caused this? 

Structured Investment Vehicles
A mortgage is simply a financial instrument where one party agrees to lend another a sum of money in order for the borrowing party to acquire a piece of real estate. The borrower, in turn, agrees to pay the borrower back through a series of payments over a certain period of time.
 
The quants at the investment banks looked at mortgages and thought, “If we put a bunch of mortgages together in the form of a separate security, we could sell that to others and make money from doing so.” These were called Structured Investment Vehicles because they were not separate transactions, but a series of transactions in one product. One example is the  Collateralized Debt Obligation. Because of this, and other technical reasons, they fell outside of accounting and regulatory guidelines. These securities were valued by considering the borrowers’ repayments as a revenue stream. Then, the lower amounts offered to the buyers of the securities were considered the expense stream. The difference between the two streams was the profit for the one who put the product together.
 
The SIV’s were sold as a way to improve the risk of the individual mortgages by spreading the risk among many participants and placing them in the larger overall financial market. This may have worked well except for a few unforeseen events.
 
The first one was the aggressiveness of the people who produced this product. Once it had been sold profitably to one level of financial institutions, the bankers decided to make more money by putting several of these products together and then selling the new, larger SIV to the next level of institution. They continued this process until the SIV market grew into the hundreds of billions of dollars and were owned throughout the world by almost all of the major financial institutions. This has created a market that never existed before, one where the basic part of the product, the mortgage, has lost all identity within the product and its market. It also one where players from all over the world find themselves relying on each other’s ability to pay as never before. Because they are all in new territory, none of the accepted rules of textbooks apply, nor does anyone have experience to provide any guidance in this arena.
 
The second was the amount of fraud and irresponsibility involved in the selling of the mortgages to the less credit-worthy borrowers. Most bankers assumed the weakest credits they would lend to generally defaulted on 4-6% of their mortgage obligations. Once the lending standards were lowered, a reasonable person would have assumed that this rate might have risen to 7-9%. However, many bankers didn’t worry about the higher default rate because they knew they were going to sell the mortgages on to another party in an SIV. As a result, they often characterized the default risks much more optimistically than reality called for. The toxic storm of lowered lending standards, fraud (by both borrowers and lenders), and irresponsibly optimistic predictions of default rates all hit at once when the market collapsed.
 
The default rates experienced in the groups of mortgages that made up the SIV’s rose to 20 -30% of the total as the SIV’s became larger and larger. When the original bank that had sold the mortgages experienced defaults in the portfolio, they passed on what they had received for the other mortgages, less the defaulted amount to the buyer of the SIV. Then, they wrote off the defaulted amounts as a loss. This process was the repeated over and over all the way up the chain. Of course, the amount of money involved increased as each new SIV was put together. By the time the SIV’s grew to the level of the hedge funds interest the mortgages represented huge amounts of money. When the fact that the hedge funds borrowed money in order to buy 2 to 5 times more of these than they themselves could buy, the figures became staggering.
 
The high levels of defaults eventually forced many of the international banks to recognize the losses they faced from these products. Although the banks did not have to disclose the amount they had invested in SIV’s, they did have to report the profits or losses from these on their financial statements. To put the size of the SIV’s involved in the sub-prime mess into perspective, in the last six months the banks have taken losses of more than $100+ billion. There are estimates that the bank’s losses could go as high as $200+ billion.
 
The product has been toxic to the hedge funds as well. Because of their leverage, the hedge funds have been particularly vulnerable. When the excess default levels hit the hedge funds many were forced to shut down the fund itself. They were forced to sell off the revenue stream for whatever the could, pay off the debt with these proceeds, and if there were anything left return it to the investors as a return of their principal. Since many hedge funds were created by the banks themselves any losses from such liquidations had to be recognized on the parent’s financial statements.
 
The losses of the internationals commercial banks, the investment banks, and the hedge funds, although much larger than ever before, can be looked at as the risk of doing business. They were supposedly sophisticated investors and were supposed to the most knowledgeable people in the world when it comes to understanding financial risk. This is one of the reasons they have been largely free of regulatory restrictions by the government.
 
TheU.S. commercial banks, on the other hand, are tightly regulated basically because they have the responsibility of being the conduit between the federal government’s monetary policies and the private sector. They are the institutions that maintain the public’s confidence in the financial system we live under. So, when they created the off-balance sheet entities to trade in SIV’s, they went beyond the regulatory restrictions. But, once they were forced to recognize their SIV losses in their financial statements, these losses began to have an impact on their capital adequacy ratios. Federal regulations require them to have a ratio of “liquid” capital to the amount of loans they have outstanding. Any losses they take on their income statements reduce their available capital. This is the reason several of the largest banks have had to borrow money from foreign sovereign investment funds recently. For example, at the end of 2007 Citicorp and Merrill Lynch borrowed $19.1 billion from these sources.
 
Unfortunately, many commercial banks are not big enough to borrow from these funds. As a result, the U.S. banks are restricting their lending, particularly in the real estate sector. This is the “credit crunch” we are facing today.  Without loans, the real estate market lacks the “grease” to operate at optimal speed and, this in turn, means more houses for sale with no buyers, fewer profitable real estate companies and developers, and fewer jobs.
 
Credit Default Insurance (CDI)
Although this is not a crisis at the moment, most knowledgeable people in the finance business have little doubt that it soon will be. This is another example where the quants saw an opportunity to make money by changing an accepted part of the market to their advantage. They applied a successful product that had a limited market to a much broader area. In the 1980’s CDI, which applied to municipal financings, was a $1.5 trillion market. By 2007, when they were applied to a wide variety of corporate and other bonds, it was a $41.5 trillion market.
 
The market started when medium to small municipalities issued bonds for their needs. Because they were not deemed to be the most credit-worthy they received lower bond ratings (AAA is the highest). This forced them to pay higher interest rates. However, since these entities hardly ever defaulted, financial companies with AAA credit offered them Credit Default Insurance, which, for a premium, gave them AAA ratings, thus lowering their interest rates and saving the taxpayers money. The AAA financial companies promised that if the municipality defaulted on any of its bond payments, they would make the payments for them. This arrangement has worked well for a long time. Defaults are rare, municipalities enjoy a lower interest rate, and the credit insurance companies have prospered.
 
Under the current administration’s policies of business friendly regulation the default rate for less credit-worthy companies has fallen to about 0.5%. Historically, this has been about 3.5 to 5%. When the quants saw this low default rate they decided that providing Credit Default Insurance (or Credit Default Swaps)  for private companies could be a very profitable activity. This was indeed the case. The market expanded rapidly, with more and more financial institutions taking part as providers of the insurance. As the market got bigger and bigger, the premiums grew as well. This, in turn, encouraged people to look for new areas where they could apply this profitable product. The latest twist is offering credit default insurance on many of the bonds that make up SIV’s, in order to get them AAA ratings. Obviously, the level of defaults in the product will have a serious effect on these transactions.
 
The established insurance companies that have historically offered this product, such as AMBAC, have already been affected by the market turmoil, but appear to be weathering it at the moment. The real frightening part of the market is the financial companies that have made up a majority of the recent activity. They offered credit insurance to more questionable companies based on the current 0.5% default rate. If we go into a recession, that default rate will surely rise. If the default rate just goes up to 1.0%, it has been estimated that it could cost the suppliers of CDI’s $1.5 trillion. It is almost beyond imagining to think about what would happen if the default rate were go up to its historical levels of 3.5-5%. And, this does not take into account the real exposure financial institutions face concerning their obligations under CDI’s offered to Structured Investment Vehicles.
 
This analysis is not meant to draw conclusions or offer solutions. History has proven that we have been able to avoid the Apocalypse; some group, somewhere, somehow has come up with a solution. Although it is difficult to see such a savior at the moment, one can only hope that history will repeat itself – again.

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Published in: on September 30, 2008 at 5:20 am  Leave a Comment  
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