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An Ailing Economy

Americans are more than ready for an economic recovery. While we remain optimistic about our future and wonder why this recession seems to linger, we are also carefully guarded in our spending and investments. I would suggest that many Americans have some deeper awareness that there are problems that have not been publicized as much as they should. One basis for this lies in the question – why aren’t the banks loaning more of the money we gave them?

This simple and basic question has complex and diverse answers. Besides, the very asking of it makes many economists nervous since our best hope of economic recovery lies in public confidence in the system – even if such is not due. Without public confidence, the house of cards built by our financial institutions will collapse. This may seem to be a remarkably pessimistic and possibly unfounded statement. After all, we’re a nation with $100 trillion (give or take a few dozen trillion) in total assets[1], around $11 trillion in public assets, almost $15 trillion in GDP (annual productivity), and some $14 trillion in bank assets. How could something as intangible as “public confidence” substantially change our worth?

We should start by looking at the idea of “worth”. As those whose worth was largely in real estate could easily explain, “worth” is largely based upon perception. During 2007 and 2008, we saw the worth of American real estate drop 30% (over $6 trillion out of $18 trillion). The real estate didn’t change, but people’s perception of worth did.

Another easy example is seen in the stock market. Stocks get the double-whammy (or triple whammy) from public confidence:  without public confidence (and spending) many companies are not profitable and without profitability, they are seen as worth far less and without public confidence, investors don’t provide capital and without capital companies can’t grow, and companies that aren’t growing are deemed less valuable. Few companies change significantly in short periods (like months), but their stock prices may rise and fall substantially over hours.

Finally, we have all heard of the collapse in public confidence that occurred during the “great depression” – when people couldn’t even trust their bank to protect their deposits. Without access to the public’s money to invest and loan, the banks were unable to perform their vital functions. Now, most deposits are insured by the government (us) and therefore seem safe. This illusion is the greatest gain from the great depression along with the regulatory framework created to stabilize and securitize our banking system.

At some point we understood that banks hold a special place in our economic system and that extensive regulation of them was essential to protect our worth. But over time we allowed banks to grow and merge, grow and merge, and grow and merge. They became huge international conglomerates with “banking” becoming less and less significant in their operational structures while they kept “bank” in their name just to inspire confidence. Along with virtually unbridled growth, the “banks” grew in influence and power. By investing a few million in politics, they reaped billions in benefits (and trillions in recent “bail-outs”). Regulatory restrictions were dropped and oversight became tokenized.

Despite the clear and compelling warning provided by the “savings and loan crisis” of the 1980s, our government allowed “banks” to move in the same misguided direction: our banks became “financial institutions” with greater and greater focus on short term profitability based upon greater and greater risk-taking. Banks merged with other types of banks, with insurance companies, with brokerages, and with investment firms to produce multinational multifunctional institutions that could not be allowed to fail – regardless of how irresponsibly they acted. Without proper regulation, banks became increasingly profit motivated and corporate boards paid higher and higher salaries to executives who produced the greatest short-term gains or profits.

In their quest to maximize profits, banks and their interrelated financial institutions began to seek new methods for profit-taking and “Yankee ingenuity” soon produced some “exotic” financial devices that could be sold for huge profits. One major category of exotic devices is known as “derivatives” – a product whose value is derived from some other product or service. Perhaps the most egregious of the derivatives are called funded “CDOs” (collateralized debt obligation) where the credit derivative is entered into by a financial institution and payments under the credit derivative are funded using securitization techniques (such as when a debt obligation is issued by the financial institution to support the CDO obligations). Associated with the funded CDOs there is a villainous device called a “credit default swap”.

Credit default swaps (“CDSs”) are akin to insurance (where the buyer pays premiums) for the seller’s promise to cover losses on specific securities in the event of a default. Originally (in the 1990s) they were almost exclusively applied to municipal bonds, corporate debt, and mortgage securities that were sold by banks and hedge funds. Then, the CDS market expanded rapidly into “structured finance”, such as CDOs that contained pools of mortgages. It also moved into the secondary market, where speculative investors, hedge funds and others would buy and sell CDS instruments from the sidelines without having any direct relationship with the underlying investment. Bank executives essentially gambled on whether certain investments would succeed or fail and during the period when our economy was growing, there were few failures and many bank executives became rich through CDS gambling.

Like the growth in casino gambling, CDS gambling expanded to the point where more than $50 trillion in coverage was outstanding by 2008. That is more than three times the value of the U.S. stock market (valued at $18 trillion) and far exceeds the $7 trillion mortgage market or the $4.4 trillion U.S. treasuries market. Then came the “crash”…

The house of cards that had been built by the financial industry had several weak points, the greatest of which was the sub-prime mortgage. Unscrupled and greedy lenders took advantage of the “American Dream” and government money to sell houses to unqualified individuals at interest rates well below the “prime interest rate” or the best rate at which banks loan money (supposedly to their best customers). The rationale was that the interest rates would increase later (as “adjustable rate mortgages”) so that a profit could be made, but that was readily seen as flawed since many of the buyers had little hope of affording the adjusted mortgage. But that didn’t concern the lenders because they didn’t hold on to the mortgages – they sold them to others.

Primary home mortgages were considered superior investments because they were secured by the value of the property and because people resisted defaulting on the house they live in (and losing their substantial down-payment). However, many of the sub-prime mortgages were offered with zero or minimum down-payment and people saw them as better than paying rent – even if they had to walk away from the house.

On an individual basis, sub-prime loans were easily seen as a risky investment and even the greediest bankers could figure that out. The first financial trick in this game was to bundle sub-prime mortgages with others and sell the bundles. It may not be overly difficult to assess the risk in any particular loan (although it is never an exact science), but it is nearly impossible to assess the risk in a bundle of many mortgages. However, a few companies specialize in doing just that: they rate investments based upon their risk.

In an astounding and mystical transformation, the risk rating companies (such as Standard & Poors, Fitch, and Moodys) would take a group of risky mortgages in a bundle and assess/rate them as low risk investments. They did this because it was profitable for them – not because it made sense or had any real basis. Of course, these companies won’t guarantee that their risk assessment is accurate, but investors still relied heavily upon their ratings.

But wait! Shrewd or prudent investors could also buy “insurance” against bad investments in the form of a CDS. But did they?

Apparently, many professional investors (e.g. “fund managers”) didn’t. Because they are under pressure to maximize “return” (and they personally have little risk), few fund managers reduced their rate of return by investing in default insurance. So we are left to wonder who it is that holds some $50 trillion worth of default insurance. We also aren’t sure just how many defaults will actually happen.

This remains the big unanswered question in our economy, along with its corollary – what will the payout be. Politicians (at least the few who really understand what is going on) are hoping that government intervention will prevent more defaults and reduce the insurance payouts to some more manageable figure: perhaps a mere $5-6 trillion. Financial institutions don’t have to reveal what their CDS obligations (or potential claims) might be. But, since they were the ones selling the CDSs, it seems unlikely that they were also buying them. My guess is that many of the CDS buyers were the insiders who knew the scope and depth of the fraud.

So here we are: stuck. The government has given banks almost a trillion dollars in the hope that they will loan that money to the businesses that rely upon loans to operate and expand. The banks want to hold that money or use it for other gainful purposes until they see where things are going. Regardless, the “credit crunch” is not the problem. Credit is still available, just not as cheaply or freely as it was. Mortgages are being offered, but only under terms far less risky than before (often where the government is guaranteeing them). People are generally uncertain about our economic future and are being very cautious with their money. The “tipping point” has yet to be reached.

There are several “vicious circles” out there: less spending means declining sales, declining sales means fewer jobs, fewer jobs means more defaults, and more defaults means less investment – and spending. The government’s solution is to “infuse” the economy with a bunch of borrowed money in an effort to break the cycle. While this may or may not succeed in stimulating the economy, it doesn’t solve the problem or problems. As many Americans can tell you, spending more money than you have only creates an illusion of “prosperity”.

But even though the national debt (again, around $14 trillion) is too high, it’s not our biggest problem. We should be more concerned about another vicious cycle: The sub-prime mortgage market collapse led to defaulted mortgages and mortgage related bonds. This collapse removed money from circulation, led many into unemployment, drained many retirement accounts, reduced property values, and curtailed spending (as above)[2]. Meanwhile, the second big round of defaults is already underway- credit cards.

Credit card debt has been a banking favorite for many years. It would seem that unsecured debt would create great risk, and it does – for both the banks and consumers. But banks have always been able to simply up their rates and fees as was needed to offset their losses. American hunger for easy credit and bank willingness to offer almost anyone a credit card has led to almost $1 trillion in outstanding credit card debt (an average of over $8,000 for every American family). As more and more people are defaulting on their credit cards, the banks have followed their traditional path and tried to charge off this loss to their paying customers. That became so egregious and unfair that the government had to legislate new restrictions on bank credit card practices. Soon, the banks will have to find new ways to cover their credit card losses.

With defaults rising in almost every financial arena, we can readily see why those who have insured against defaults are in trouble- BIG trouble. This is why the CDS market has even wider and deeper ramifications than the subprime crisis. When bond insurance becomes too expensive (or disappears), lenders become more cautious about making loans – even when the government is giving them virtually free money to loan. The result is that everyone who relies upon borrowed money is in trouble. Businesses, mortgage-seekers, and municipalities are among the hardest hit – and each of these are part of one of those vicious cycles described before.

National governments around the world are not just trying to stimulate their economies with infusions of borrowed money: they’re trying to break the vicious cycles that can lead to greater economic collapse. The hope is that we can restore sufficient confidence in the future to restore spending and lending and that this will lead to a growth cycle that will allow repayment of the massive debt we’re creating. Since there are few other options, this idea has merit. The BIG catch and barrier to success remains hidden: the CDS obligation.

We don’t know who holds the $50+ trillion in CDS debt or claims. Nothing obligates either side to reveal these details. We could hope that much of the debt will be cleared by reduced and settled defaults. In some cases, the insurance holders will suffer default themselves. Many will be settled for less than the original guaranteed payout. But even under optimistic circumstances, there may well be over $5 trillion in CDS debt due. The banks cannot cover even a small percentage of that – even the ones that are not billions of dollars in debt to the government.

I propose a simple solution: legislate it away. Yes, simply pass a law that says that no one has the right to collect upon a CDS debt (“insurance policy”). We don’t know exactly who would be hurt by this, but there’s little room for sympathy for them. Besides, many are undoubtedly those who created the problem in the first place. In turn, we break up almost every one of the vicious cycles mentioned above and offer a valuable lesson to the financial marketplace: risky debt is always risky debt.

There are many ramifications to this idea and some are bad. At the very least, it would be interesting to get the idea out there and see who “comes out of the woodwork”. At the worst, we have pressed a very large “reset button” and will get a clean start on our new economy. Hopefully, with lessons learned and a brighter hope for recovery, we can return to an era of fiscal responsibility – public and private.

 

31 Oct. 2009

Rich VW



[1] In 2008, the U.S. national wealth consisted of $10.2 trillion of publicly owned assets, $54.2 trillion of privately owned assets (with some $16 trillion in retirement accounts), $57.2 trillion of education capital and $3.9 trillion of R&D capital, for a total of around $125 trillion. However there were almost $8 trillion in foreign claims against those assets and our national public debt exceeds $13 trillion.

[2] Another vicious cycle begins within this one: less spending deprives government of sales tax revenue, lower property values deprive government of property taxes and capital gains taxes, and higher unemployment deprives government of employment taxes while increasing costs for unemployment insurance payouts and public assistance – further reducing spending.

 

 

 

 

 

 

 

 

Please let me know if you have comments about or corrections for this web site.

rich1vanwinkle@yahoo.com


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