The End of An Era?

June 17, 2008

Dear Citizens and Elected Officials:

I’m pleased to offer for your consideration an essay, multiple book review and “primer” about our financial crisis and its implications for the broader economy. I intend it to be in three parts, and this is the first, with a “crash course” on those terms that Paul Krugman won’t explain to you folded right in. I also introduce the authors as well as bring you up to date on where we are in “The Great Unwinding.”

The Washington Post Series of the past three days on the mortgage calamity, called “The Bubble,” did not mention any of the authors I cover. We seem to have a very different perspective. Imagine that.

So if derivatives, Credit Default Swaps, Interest Rate Swaps, hedge funds, leverage, margin and collateral are scary terms, they won’t be when you finish. I’ve found some able guides to lead us upstream to that financial “heart of darkness” where others fear to go. Then you’ll be able to read the President of the N.Y. Federal Reserve Bank’s speech on these topics in 2006 with no trouble at all, and compare it to what’s actually happened.

Part Two will explore the different ways these authors approach the issues implied in the title – The End of an Era? I decided to insert a question mark because of the grave doubts raised as to whether our political system is up to the task of correcting the excesses of the market fundamentalism that brought us to our unhappy present state. And we will explore the relationship between the “real economy,” and the semi-virtual one that has emerged in the world’s financial markets. There will also be compact book reviews so that you can judge which one is right for you. A very brief outline of reforms and how progressives might put them “on the table” - will be served.

If this seems a bit too daunting, then you can always punt and leave the reforms to the bi-partisan group of insiders that got us here, the ones who have been relying on “market discipline” to solve problems apparent since 1987. They’re working on their versions now, and from what I can see so far, not only will the grand speculative casino continue, but they’ll give you a center stage visitor’s pass for the stock exchange floor, taxpayer wallet opened wide, and pushing the broom to clear away the debris. Our authors will tell you who they are, Democrats included. Then you’ll be able to better understand why banks and credit card issuers were so successful in pushing up fees and penalties against consumers in Congress, while regulators repeatedly refused to raise the margin and collateral requirements for market speculators along The Street.

Now let me quickly introduce the starting lineup: Kevin Phillips you know already, the prolific political writer, who also grasps the political economy. Charles R. Morris is new, a lawyer and former banker who has written a solid, near-insider account of what’s coming down. George Soros doesn’t need much of an introduction; he was so disturbed by the August 2007 crisis he came out of retirement to oversee his investments - before they disappeared. Mark Taylor will be new to you, unless you’ve read my book review on Amazon; he’s the most worldly Wall Street savvy chairman of a religion department you’re likely to ever come across (Columbia University); Richard Bookstaber is a current hedge fund manager with a lot of experience at major Wall St. firms; and finally, Robert Kuttner has been writing about economics for decades and has given us an encyclopedic compilation of dates, events and people who shaped the managed economy that emerged out of the New Deal – and then, starting in the 1970’s, he tells you who dismantled it, and why, to bring us to the current state of the economy.

Best,

Bill Neil
Rockville, MD

PS If you are feverish with high oil prices, and have peak oil on the brain, you probably want to get right to those topics, covered very well in Kevin Phillip’s Bad Money, but which I don’t focus on in Part I. My views are very close to George Soros’ as recently presented in his Senate Commerce Committee testimony, and summarized very succinctly here at Energy Bulletin on June 9th, 2008. Soros acknowledges a speculative element on top of increased demand and has a very interesting view of supply constraints, including a “backwards sloping supply curve.” His book tells you why he’s always been suspicious of the conventional supply and demand curves. Here’s the link: http://energybulletin.net/45624.html [1]

If you would like to learn more about the housing bubble and mortgage fiasco, please come and hear Dean Baker, one of the few economists who called the bubble early on, and Maryland’s Commissioner of Financial Regulation, Sarah Bloom Raskin, for the state and local perspective, on Tuesday, June 24, 2008, at 7:00 PM in the new Rockville Library, 21 Maryland Avenue, Meeting Room 2, Second Floor, at Rockville’s Town Center, Sponsored by Democracy for Montgomery County.

THE END OF AN ERA?
June, 2008
William R. Neil

PART ONE

Introduction

Like many citizens, I wondered during the high tide of Market Utopianism in the late 1990’s, whether the great bull market of 1982-2000 would ever end, even though I had more than my share of doubts, thanks to John Kenneth Galbraith’s (RIP) writings, that markets could permanently break free of the earth’s gravitational pull. I always had it in the back of my mind, even as those daily postings of market quotations (entirely secular versions of the Angelus bells from the late Middle Ages, and still echoed by the “closing bell” at the N.Y. Stock Exchange?) rang in yet another “advance” on the Dow averages, that the place to look for trouble would be in the vicinity of the latest financial products from “The Street.” These products would be the ones created just at the edge, or over the edge, of the existing regulatory structure, such as it has been: a structure none too worried or inquisitive about what the financial geniuses were cooking up. Until now.

There is a train of logic here, which evolved during the decades of the reign of the Republican Right, 1980-2008, and which captured a good portion of the Democratic Party as well, as the Clinton years so sadly demonstrated: if all of human history was pointing towards the emergence of free-market democracies as the highest form of societal evolution (Fukuyama), and if the United States since Reagan was the perfect embodiment of this trend, and if “…Wall Street stands at the metaphorical heart of American capitalism…”(from Steve Fraser’s Wall Street: America’s Dream Palace, 2008), and, if we add in goodly if not Godly doses of Market Utopianism and overtly religious symbolism (One Market Under God, by Thomas Frank, 2000 – a vastly under-appreciated work, prior to his Kansas gem.) then – who are we as mere civilians distantly observing the alchemists of market innovation at work – to dare question the new products? Simply put, if the mathematical economists from MIT increasingly hired by The Street – “the quants” – could think them up – then they should be put in play. And they were. And how. Despite all the early signs of trouble, some very closely connected to the new instruments and new market technologies – like the October 19, 1987 stock market crash, the demise of Kidder-Peabody in 1993-94, the Orange County, California bankruptcy in 1994, the collapse of the hedge fund Long-Term Capital Management in 1998 (advised by two Nobel Laureates in economics), the collapse of the dot-com mania from 2000-2002, the Enron “ ‘accounting’ experience” – The Street and its worshipful regulators embarked upon financial inventions the likes of which the world had never seen since the much simpler ones of – steady now – 1929.

Let us pause however, even if just briefly, to push the gloom of the economic reality of mid-2008 aside (and its $135/barrel oil) and recall, in true wonderment and tribute, those boom years of 1997-99, the golden years of the Clinton achievement which still glow, at least in the minds of the faithful, and there are many, even as they de-regulated the way for our troubles to come. These were years so effervescent that it seems now, in retrospect, amazing that Scott and Zelda Fitzgerald did not emerge from their resting place in St. Mary’s Cemetery, Rockville, MD, and dance a giddy, ghostly Charleston atop some nearby SUV hood, stuck in traffic at five points, close to the “metaphorical heart” of consumer culture there along the Rockville Pike. Oh well… the green light shone on for Wall Street for a little while longer….

Since these were also the years (1988-2001) of this writer’s deep immersion in the Somme-like environmental trenches of public policy, he, like most of his fellow citizens, hard-pressed for spare time, was entirely too trusting in the hope that someone else was looking after society’s interest in keeping financial markets as the servants of the public good, rather than the demanding masters – or worse – that they have become. Yes, I said worse, thinking of the recent article about Credit Default Swap Indexes which used the term “Frankenstein’s Monster” to describe the impact that the indexes were having on the cash bond market – driving prices there – rather than reflecting underlying realities, if those increasingly elusive realities could indeed still be located and distinguished from the “virtual” ones. As we will see, Credit Default Swaps (CDSs) are high on many lists of the next big financial innovation likely to go bad after the collateralized mortgage instruments. Starting out as rather simple “insurance policies” to hedge against corporate defaults, CDSs have “spawned a market covering $45 trillion of bonds and loans where no one knows how much is traded and speculators who bet on deteriorating credit quality end up forcing that reality.” (“Swaps Tied to Losses Became ‘Frankenstein’s Monster’ by Neil Unmack and Sarah Mulholland, Bloomberg.com, April 15, 2008, at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aMX2xgJrrGB8 [2]

Just as this essay is about to go to press, it seems a new exchange is about to be set up to help ease the CDS worries, along the lines suggested by one of our authors, Charles Morris. Whether they will impose the higher margins he implies remains to be seen. See the article by Matthew Leising, “Wall Street Lands First Blow in Clearing Credit Swaps, June, 9, 2008 at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aWr5oZMeVsbU [3] .

Welcome to the world of financial engineering, a postmodern world so abstract, so daunting that even those closest to the drafting tables of the new innovations, and charged with assessing their risk, write books entitled A Demon of Our Own Design, and warn that “the financial markets that we have constructed are now so complex, and the speed of transactions so fast, that apparently isolated actions and even minor events can have catastrophic consequences.” (Richard Bookstaber, A Demon of Our Own Design, Page 1.)

Indeed, during his early winter 2007 research into the realm of “derivatives” – the broadest term used to describe the products of the new financial architecture – this writer was so startled by the nature of the metaphors used by the risk managers and alchemists themselves to describe their new creations – metaphors of natural and man-made calamities and catastrophes – that he felt that these were barely disguised distress calls, tinged with resignation, especially over how they would perform in “recessionary” times, like the one looming over us. Thinking back over these sources, he can’t help but think that these signals formed, in their own way a mood similar to that created by Director Clint Eastwood for the film Letters From Iwo Jima: these were “letters home” from those trapped on an ideological island, soon to be overwhelmed by forces they have helped to set in motion. (The protagonist in Letters is not so sure he wants to die a fanatical death for the Emperor’s hopeless cause.) Readers are invited to offer up their own “scary island” metaphors, especially ones where the inventions turn on the inventors.

For those who missed the movie, I offer several alternative journeys: one far upstream to the financial “Heart of Darkness,” or, if you would prefer, to be more contemporary, to the heart of “The Matrix,” as we ponder, together, the work of six very different authors writing about the financial system and the state of the US economy in the wake of the greatest financial crisis since the 1930’s, the one that has kept credit markets in a state of turmoil since it first introduced itself in August of 2007, and the one that may yet usher in a new era.

Here are the books reviewed, in roughly the order in which they appeared in print. The full titles are given, to give you a better idea of what is to come, as well as current prices at Amazon.com. The prices are still quoted in dollars, but, as we shall see, that may change in the not-too-distant future.

Confidence Games: Money and Markets in a World Without Redemption by Mark C. Taylor. University of Chicago Press, 2004. $18.72 (paperback.)

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by Richard Bookstaber. John Wiley and Sons, Inc., 2007. $18.45

The Squandering of America: How the Failure of Our Politics Undermines Our Prosperity by Robert Kuttner. Alfred A. Knopf. 2007. $17.79

The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash by Charles R. Morris. Public Affairs, 2008. $15.61

Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism by Kevin Phillips. Viking, 2008. $17.13

The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means by George Soros. Public Affairs, 2008. $15.61

The Subprime Crisis – and Beyond

The American public has heard a great deal about the beginning of our story, how the housing bubble, which began its great price run up in 1997, was done in by massive overbuilding, backed by millions of subprime mortgages written to support it, and the massive amounts of new debt instruments marketed upon their shaky foundations. But as the titles to the books reviewed here suggest, this is only part of a much larger story. What began in June of 2007 as a crisis in two of Bear Stearns’ mortgage-based hedge funds has continued to spread to financial markets few had ever hard of, such as the auction-rate securities market run by major banks/securities dealers, which collapsed in the early winter of 2008 and which affected local governments nationwide, as well as a wide variety of other public entities, such as the Port Authority of New York-New Jersey.

As Kevin Phillips rightly points out, “housing…had become the lit fuse of a potential debt and credit explosion.” (Page xii.) Charles Morris, a lawyer and former banker, concurs, noting that “subprime…is just the first big boulder in an avalanche of asset writedowns…an overhand of subprime-like assets, at least as large, is sitting in corporate debt, commercial mortgages, credit cards and other portfolios.” (Page xii.) Avalanche is a metaphor which crops up often to describe the theories about rapid transformations in complex systems, like the financial markets, from one state to another. It appears in Mark Taylor’s book as well. One moment, it’s a beautiful, placid hillside; then a loud noise, a tree shedding snow – small event – and suddenly an invisible critical mass is triggered and things are swept away.

But let’s give the subprime mortgage fiasco its full due. Here’s how it stands in early June, 2008. The New York Times reports that “about 1 in 11 American mortgages were past due or in foreclosure at the end of March…a figure that is rising fast as home prices fall and the job market weakens.” (“About 1 in 11 Mortgage holders Face Loan Problems, by Vikas Bajaj and Michael M. Grynbaum, June 6, 2008). House prices have fallen about 10% from their peak, and some observers, like George Soros, feel they may have another 20% to fall. Economist Robert Shiller, who called both the stock market bubble of the late 1990’s and this housing bubble (along with economist Dean Baker and a very few others), predicts declines in prices in some regions of 50% with total losses approaching $10 trillion if it cannot be contained, more than the $7 trillion lost in the 2000-2002 stock market slump. (Phillips, pages 9-10). Some forecast that as many as one-third of all the mortgages in the nation will be “upside down” or “underwater,” which means that the market value of the house will be less than the mortgage owned. This would be close to the figures from 1933 in the Great Depression, before New Deal government intervention helped. These inverted mortgages are likely to dramatically block that favorite borrowing route called “re-financing,” and weigh heavily on job mobility at a time of rising unemployment. The losses in the debt instruments backed by these mortgages are estimated at $450 billion by Morris in his grand table of “Defaults and Writedowns” (Pages 130-131). If the recession deepens and defaults spread beyond subprime, as the New York Times article indicates is starting to happen, then the collateral damage will increase. The new economy is full o feedback loops; as asset prices fall, the new debt instruments, many highly leveraged, based on this shrinking collateral base, will be worth less and less, and further write downs will shake the financial markets. We’ll see a bit later on how things can head south very quickly for highly leveraged speculators, and it doesn’t take much of a drop in asset values to set things off.

One repeatedly hears from those opposed to Congressional assistance for the millions of citizens likely to lose their homes, especially the subprime mortgage holders, that the burden for the fiasco falls upon them, the individuals who signed loan terms they didn’t understand and couldn’t afford. True enough, for those situations where the real terms were fully disclosed. Individual responsibility is always part of the American economic story. But it usually is not the whole story, and maybe less than half of it, as our authors make very clear. Kevin Phillips doesn’t even want blame to rest disproportionately with the new mortgage lenders themselves, with firms like Countrywide Financial, which would seem to be logically next in line for the public tarring, after the homeowners. Phillips instead casts a wider net of responsibility:

…this time there were huge institutional pressures to entice as many customers as possible, reflecting the enormous profits to be made from taking mortgages and securitizing and repackaging them en masse in what became…mortgage backed securities and collateralized debt obligations… Lenders needed to woo high-risk borrowers for the good commercial reason that there weren’t enough low-risk borrowers to meet the volume demanded by the big commercial banks, and other packagers, all pursuing lucrative fees…Between 1987 and 2007…credit market debt roughly quadrupled from nearly $11 trillion to $48 trillion. This was abetted by a revolution in marketing, packaging, and propaganda – in reality, public debt wasn’t the big ballooner, private debt was. (Phillips, Pages vii-viii.)

Soros is equally scathing in his sketch of institutional responsibility for the calamity, tracing the evolution away from neighborhood mortgage underwriting and responsibility to a nationwide, high-division-of-labor system – a “factory” like system that was fee driven throughout – one that spread the final resting place of the CDOs – and the risk – to the remote investment corners of the globe (after all, this is the age of globalization). Because of the shortage of actual physical mortgages, the system turned to the manufacturing of purely synthetic packages, a theme we will return to later. Since Soros’ foundations have become involved in aiding the homeowners in distress – in New York City, Baltimore, Prince Georges County and the State of Maryland – he is in a position to note that senior citizens seem to have been targeted and disproportionately affected in some areas, as well as communities of color (Pages 146-7).

While the housing/mortgage crisis and the related troubles of major banks like Citigroup and Bear Stearns have garnered increasing attention in the mainstream press, there are other little known but remarkable stories which reveal the systemic nature of the new financial architecture. It is causing trouble in some especially economically hard-pressed regions of the old manufacturing economy, the remaining U.S. fragments of what some still call the “real economy.” I’m intrigued because the new financial instruments here under scrutiny were based on interest rates, interest rate swaps and swaptions, as well as adjustable rate bonds. My first formal venture into the new financial architecture had warned me in February of 2007 that interest rate behavior and predictions were causing some of the best economic minds a lot of trouble – and that central banks had lost control of the vast flows of unregulated speculative capital. Some economists feel these flows now had become powerful influences on interest rates, especially mid- and long-term ones. My reaction to the municipal plight described below spans the range from disbelief to anger: I can still see Jim Cramer on CNBC mimicking the sneers of sophisticated Wall Street brokers/bankers around the water cooler who have just unloaded the latest financial innovation onto the unsuspecting rural German bankers (his example)… Now we learn how Pennsylvania school districts and an Alabama County got themselves in far over their heads – and please note the similarity to fee driven systems with variable interest rate products being marketed as the “smart way to go” – to lure, in these cases, not prospective homeowners, but the usual issuers of long term municipal debt – local governments themselves.

The Slaughter of the Innocents

Thanks to the fine reporting of Martin Z. Braun and William Selway of Bloomberg.com , and to Pam Martens who steered me to their February 1, 2008 article “Hidden Swap Fees by JPMorgan, Morgan Stanley Hit School-Boards,” at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ay5LDbjbjy6c [4] we know the Pennsylvania legislature passed a law in the fall of 2003 (by votes of 197-0 and 45-0 in the two houses!) authorizing its cities, local school districts and counties to engage in derivative purchases, specifically interest rate swaps, with the rationale that they could reduce their borrowing costs from the traditional long term fixed bond rates. The pitch was: the new financial products meant you didn’t have to get stuck for 30-40 years in rates that were too high, so get with the latest the private sector offers. Don’t let the terminology scare you off: derivatives are financial instruments “derived” from some underlying asset, security, or benchmark(s). Interest rate swaps have been around for a long time, starting in the 1970’s with corporate attempts to manage and hedge risk from changes in interest rates and currency differences across national borders (and evade national regulations too). Since then, they have evolved into many different forms and can serve as both a hedge against abrupt shifts in rates, or unfavorable long range trends. They also can serve, even at the same time, depending on how the swap is arranged, as speculative instruments. The major banks named in this article have long experience in arranging these derivative products on terms favorable to themselves, and have the models to predict and control their risks. The school districts, like Erie, had to rely upon their own advisors, and their knowledge and independence, such as it was, to guide them. The appeal to old industrial regions that had lost their manufacturing base and sizeable parts of their population since the early 1970’s is that the banks would offer some cash upfront. However, they also structured their undisclosed feeds into their calculations and by privacy agreements prevented the local government from comparison shopping with similar deals made with other governments. The municipal hope was also that the variables in the deal – which way interest rate spreads went on certain specified benchmarks – would save them money from the high interest rates that they seemed to be locked into for their bonds if they followed traditional financing routes. But the wild card – the interest rate spreads – went the wrong way for the locals, in this case the Erie School District and they had to spend $2.9 million to break the deal and cut their losses, after collecting only $750,000 from JPMorgan Chase. According to the article, banks have “pitched” some 500 deals putting $12 billion in play. Fortunately, only 15 PA school districts went for interest rate swaps in deals worth “just” $28 million. Governor Ed Rendell, who signed the bill in September of 2003, setting all this in motion, now says that “‘the school districts are getting fleeced.’” Readers should beware, because a total of 40 states have also gone this route.

Now the main line of defense for the promoters seems to be the surprising reversal in the direction of interest rate spreads. It should serve as a warning, though, for any local or county official contemplating going down a similar route and reading this review: there is no riskier time to play this game of guessing interest rate direction than just now in the summer of 2008, with the Federal Reserve torn between fighting inflation and a recession. The Fed’s interest rate actions can go either way and the continued turmoil in international financial markets abroad means there is no certainty from the private rate direction either. So don’t do it, because from what I read in this and the following article, all the safety clauses and terms for the options that the banks have built in if the rates don’t go the way they are betting – means the local end of the swap or swaptions will have to pay more than they understood – or bargained for. And it appears to be very difficult to get truly independent evaluations. If these deals didn’t work for the locals in the relatively quiet and predictable interest rate sea of 2004-2006, placid waters indeed in comparison to the rip tides we are currently negotiating, then this is no time to set sail.

And if there ever was a time for market surprises, this is it too. Didn’t think interest rates would defy convention and go the wrong way? How about a nationwide decline in home prices, which again, no one eve thought could happen (local markets yes, nation as a whole, no. That premise is one that made the designers of the new mortgage packages, CDOs, especially the synthetic ones, so confident that they were reducing risk by creating pools of 5,000 from around the nation…Soros, Pages 117-118). Of course, the memory of 1929-1933, when nationwide declines did actually happen, has been virtually erased from the conventional wisdom. If we are really at the end of an era, and standing at the equivalent to the end of the 1920’s, predictions “into the 1930’s” will be pretty tough, even if we manage to evade something that drastic. Soros believes 1929 will be averted, thanks to the lessons learned and Fed Chairman Bernanke’s academic focus on them. Morris, Kuttner and Phillips give a range of possibilities, some of which, if not the equivalent to 1929 – make for pretty grim “unwindings.” It’s clear conventional thinking is going out the window pretty fast in 2008. (Stay tuned for Part II and more on these broader themes).

Things were shaky enough for these Pennsylvania school districts, but now Jefferson County, Alabama is poised at the edge of becoming the nation’s largest municipal bankruptcy ever - $5.8 billion, based on interest rate swaps and adjustable rate bond agreements they entered into with JPMorgan, Bank of America, Bear Stearns and Lehman Brothers Holdings Inc., between 2001-2004, all done to help save them money in financing a new sewer system. Once again, it’s an old industrial area, including the “Pittsburgh of the South,” Birmingham. What went wrong? Reporters Selway and Braun put it this way: “Like homeowners who took out mortgages they couldn’t afford and didn’t understand, Jefferson County officials rejected fixed-rate debt and borrowed instead at rates that varied with the market.” (My emphasis.) But just as we have seen from Phillips’ and Soros’ perspectives on the subprime crisis, we again have fee-driven proposals, with the fees here collected by the banks (and layers of intermediaries) and the independence of the brokers pushing the deals being questioned – in this case really questioned – by the FBI, the SEC and the Justice Department. And this story does loop back into the subprime mess, because of the collapse of the adjustable rate bond auction market and the fact that Jefferson County’s bond insurers, Financial Guaranty Insurance Co. and XL Capital Assurance Inc., were badly hurt by losses in securities connected to subprime home loans and were downgraded by Standard and Poor’s and Moody’s. This downgrade, according to Selway and Braun, then led to Moody’s cutting the county’s sewer bonds themselves to Baa3, “one step above junk. The downgrade triggered clauses in the county’s swap agreements. Bank of America, Bear Stearns, JPMorgan and Lehman Brothers now had the right to cancel the deals – at a cost of $277 million to the county.” Read it here for all the gory details, and weep too, because the phrase that kept coming into my mind as I went through it – over and over – was “the slaughter of the innocents.” Here is the link: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aF_f8gLLNvn0 [5]

So there is not just a series of unconnected random economic events troubling the U.S. in 2008, or, as one of the speakers at the Brookings “Roundtable” on the subprime crisis suggested on March 14, 2008 in Washington, DC, the day we learned Bear Stearns was going under – due to an “economic perfect storm.” No, what we are undergoing has too many of the same themes and patterns woven into it, as the remarkable similarities between the mortgage crisis and the municipal bond crisis described above show. The authors covered here, especially Phillips, Kuttner, Morris and Soros, tell us about the remarkable growth of the financial sector in relation to the “real economy.” Soros describes what we are facing as a collapsing “super-bubble,” consisting of three trends: the relentless expansion of debt/credit in relation to GNP, the globalization of financial products, and the “progressive removal of financial regulations and the accelerating pace of financial innovations.” (Chapter 5: The Super-Bubble Hypothesis). It is this third trend, the lack of regulation and the growing scope of the financial innovations in derivatives that is at the very core of the financial crisis, and is spreading to the rest of the “real economy,” and this is the greatest of mysteries to the general public – and if you believe press accounts, was a mystery as well to some of the most recently departed heads of the very banks which have bought most heavily into this brave new world.

To the Financial Heart of Darkness
Now I’m going to share with you the findings from my own journey to the very core of this financial “heart of darkness,” undertaken in the early winter of 2007, which led to my warning essay Fiscally Responsible or Ingredients for an Economic Katrina?, and which have been supplemented by further excursions, including the works listed above. A warning: I’ve found no completely satisfactory guide, and that should serve as a cautionary to us all, and not a criticism of the efforts that have been made. But I think we can get at the gist of it, even if complete comprehension in detail (and the ability to explain it to others) seems to be beyond human reach just now. I don’t know if the stories from the first crisis period of August 2007 are true or not, but they convey the point I’m making here pretty well: if the Chairman of the Federal Reserve, Ben Bernanke, had to take a “refresher course” from hedge fund managers, then we should all shudder a bit. And I had a very similar experience to Robert Kuttner in the course of my initial research. He tells us that when he started out working on The Squandering of America he “did not set out to write an alarmist book. But the deeper I got into the details of the U.S. economy, the more alarmed I became.” (Page 304).

Readers should not feel intimated by the difficulty of the concepts. After all, the heads of Citigroup, Merrill Lynch and Wachovia had trouble staying on top of these innovations and the risks, and yet they walked away with tens of millions after seeing their firms lose tens of billions. But you, the reader, just have to get the gist of it, and you won’t have to walk into an over-the-counter operation and place your own bets, even if they would let you. Which they won’t. However, if the failure to understand cost these banks billions, our failure to grasp what is going on is going to cost us, the citizen-taxpayers, not hundreds of billions, but perhaps trillions to clean it up. I think that makes it worth a try, don’t you? I’ve found some pretty good guides, and I’ve filled in the gaps with my own trail markers. So here we go.

Exotic Derivatives, High Leverage and Shrinking Collateral
These are the danger words at the heart of our troubles. Now some derivatives, which consist of futures, options and swaps, and their many variations, are not new. Futures and options have been around for a long time. Our grain markets since the nineteenth century have relied upon the Chicago future’s markets. Now we have options on futures’ contracts. But the major action in today’s derivatives markets is not regulated like grain futures. It’s over-the-counter, and in some crucial cases, off-the-books of major players, like investment banks and hedge funds. We said earlier that derivatives “derive” from some underlying and more fundamental asset: a mortgage debt, a bond, a stock, now stock indexes, an interest rate or set of rates, including currency rates, but the remarkable, important trend is the steady movement away from the real, tangible asset to instruments which are options, or bet upon these assets and their future price directions, and in some cases are bets upon bets upon bets: will the interest rates go up or down or the spread between different ones narrow or widen, same for currency relationships and stock and future indexes. In the case of Credit Default Swaps, which everyone is worried about, these started as simple insurance policies against corporate defaults, but now, like the other instruments, they have evolved to cover indexes and the collateralized debt obligations and collateralized loan obligations (CDOs and CLOs). For these collateralized instruments, remember that no matter how high the pyramid of new instrument creation climbs away from the underlying actual “asset” or debt itself, the reality it is based on still consists of some stream of hoped for payments from people, those in debt, from their mortgages, credit cards, auto loans, corporate bond debt…if those payments falter out of the models’ ranges, then there will be trouble.

More remarkably, there are now “synthetic CDOs,” meant to mimic the movements of real underlying assets or collections of thousands of them, with the advantage to the originator of not having to manage “buying and warehousing” the actual underlying asset. In Morris’ telling, the synthetic CDO is built from “an array of swaps.” The creators mix instrument types, and can build CDO’s out of CDOs, which gives you CDOs squared, and there are even CDOs cubed. Morris cheerfully concludes this topic by noting that “very big, very complex, very opaque structures built on extremely rickety foundations are a recipe for collapse.” (Page 79).

Those rickety foundations lead us right to the consideration of leverage and collateral. The terms go together. The game on “The Street” is to get as much leverage on as little collateral as possible, and when you have to put up collateral, borrow as much of it as you can from someone else. If you have more bets upon a shrinking “collateral base,” you can also be sure of increasing “collateral damage.” Feeling comfortable so far, citizens?

The best “walk-through for what leverage is and how it works, and I walked through a lot of them, comes from Adam Hamilton’s article, “The JPM Derivatives Monster,” from Sept. 7, 2001 at http://www.zealllc.com/2001/monster.htm [6] He strolls with us through the use of a “humble option…one of the simplest forms of derivatives,” an option being the “right to buy (call) or sell (put) a certain investment at a contractually set price for a limited time in the future.” If we were to start at the “cell” level of leverage, if we have $5,000 to risk in the market, we could buy 100 shares of a stock at $50 per share and end up with no leverage at all. That’s what ordinary citizens do, but not the “real players.”
But if we want to use the same $5,000 to play options, they are priced at just $1 dollar a share (in this example of Hamilton’s) and come in blocks of 100 shares, so for the $5,000 we get to buy 50 option contracts which gives us “control” over 5,000 shares, creating leverage of 50x. What we formally purchase is a seven month contract with an option to buy at a “strike price (or trigger price) of $55, costing us that $1 an option share. If the price of the stock runs up to $75 at the end of six months, we’ve made $20 per share times the 5,000 shares we “control,” or a nice $100,000, which cost us only the original $5,000. The nice thing about simple options is that if the price falls to say $25 a share, we are only liable for the original $5,000. Unfortunately though, this brake or “floor” on losses, does not apply to most of the new derivative instruments, as we will see with another guide. Hamilton cautions: “many other more exotic derivatives have dangerous unlimited loss potential and can ultimately destroy far, far more capital than what was actually paid for the financial instruments.”

So where is the “leveraging” happening in this example? It’s happening at the pricing of the options at $1 per share – way, way below the actual market price of the security at $50 per share and our right to buy at $55. And this is where most of the “guides” assume too much. Perhaps they’re too close to the market action, and leave important things too implicit. But it’s that low, low option price that’s driving the leverage action here. Raise the price of the option per share, in effect raising the margin, and the leverage would shrink.

In this example, that $5,000 is both our capital (in this case, it was safe capital that could be spared) and collateral. But what about the term we used above, “shrinking collateral?” Well, that’s a relative term. The amount of collateral posted can “shrink” in relation to the size of the bets piled up upon it through the use of extensive leverage. (And in the sense we are using it here, collateral is synonymous with the term “margin,” what the deal broker holds to back up the speculative bet.) In this simple example, the potential losses are known and covered with the $5,000 put up. With more complicated instruments, when things start to head south, the broker will issue a “margin call” to post more collateral.

Now in some markets, like the increasingly important “repo,” or “repurchase” market, troubling things have been evolving since the 1990’s. Taylor tells us that in the repo markets, which, by the way are, once again, not accessible to you the average citizen investor, “it had become possible to borrow money to buy securities and then use the very securities purchased as collateral for the loan. Since such deals are always highly leveraged, if the price of the security declines, the value of the collateral decreases and sometimes margins have to be called.” (Taylor, Page 177).

That’s bad, because to meet the margin call you sell the security (if you’re caught in this example), often a huge block of it, which further drops the price and tips the alert, shark-like market players that someone is in trouble and that further price declines are sure to follow…and that you better hold off making a bid for that security, because the price is going down and no one knows where the floor is…and so suddenly…the market freezes and there are no buyers until someone can figure where the floor is…and that, folks, is a brief description of how liquidity – a good match of buyers and sellers – disappears, and fast. As Bookstaber puts it in his description of the collapse of the Long-Term Capital Management hedge fund in 1998: “Who wants to buy the first $100 million of $10 billion of inventory knowing another $9.9 billion will follow?”{My emphasis}. (Bookstaber, Pages 93-94). Do you see now why in the Bear Stearns “unwinding,” the Federal Reserve had to pledge back up of $30 billion for its obligations that are to be “unwound,” ever so slowly, and discreetly, over ten years, by the asset management firm BlackRock, Inc. ?

We’ll have more to say about Bookstaber and his book later. For now, because he has been a near-insider on The Street, at a number of major firms, is a current hedge fund manager, and , as he says in chapter one, has been “in the vicinity” of a number of its most famous crashes, he was the author to add some gritty “Street” reality to my own inquiries, and no one can tell you better how fast that much touted “liquidity” supplied by the innovations can disappear, something the Maestro (Alan Greenspan) and Timothy G. Geithner (current President of the Federal Reserve Bank of New York and a key actor in the Bear Stearns deal – and much else) didn’t bother to emphasize in their public offerings. (I’m especially thinking of a Geithner speech to the Hong Kong Monetary Authority on September 5, 2006). Actually, reality between August, 2007 and today was worse than Bookstaber feared. Not only was liquidity lost on a number of occasions, the ability to establish a price, any price, disappeared for the most toxic of these mortgage instruments. If you can’t establish a price, you can’t hope to achieve a market, much less one with good liquidity.

Careful readers will note something rather prominent missing from this section so far: hedge funds. These funds are virtually unregulated, and have high thresholds to enter: reserved, therefore for very wealthy investors. (But the collateral damage from their losses may not be so “reserved.”) And they’re opaque, not transparent at all. Bookstaber maintains that calls for greater transparency will kill liquidity suppliers, as the example he gave above hints at. (Bookstaber, Pages 225-226). Perhaps. We’ll discuss reforms in subsequent parts of this series. As of mid-2007, Morris tells us that hedge funds deployed between $1 to $1.5 trillion of their own capital, leveraged many times, of course. Kuttner tells us that in 2005, there were 2,073 start-ups and 848 shut-downs, to give you a sense of the easy-come, easy-go in the unregulated market ether. (Kuttner, Page 111). Estimates of how many are active today come in at about 8,000, with a lot of uncertainty. And, as this writer has noted elsewhere, they don’t fit so well into democratic theory or practice, at least so far as these notions apply to the world of The Street. Hedge funds now span so many investing specialties, as Bookstaber tells us, that it is somewhat futile to try to categorize them – they now range across the entire spectrum of derivative instrument – in brief – they represent the investing universe itself. Fair enough, and Bookstaber is perhaps too easy on them. You can be sure that Chairman Ben Bernanke has to worry about which way they are “leaning” – which way they have bet on market directions – when it comes to changes in interest rate direction – especially critical for the recession/inflation dilemma we are staring at now. They can pull banks down with them as they go.

Morris: No Fan of Hedge Funds
Charles Morris is not as keen on the hedges as is Mr. Bookstaber. His handling of them in Chapter 6, “The Great Unwinding,” of The Trillion Dollar Meltdown, is the best I’ve read, and delivers the critical edge I think the public needs right now. He focuses on their extensive participation with Credit Default Swaps (CDSs) and CDOs – the collateralized debt obligations, of which the mortgage instruments are now the most infamous subcategory. Hedge funds account for about 60% of the trading in CDSs, a market worth about $45 trillion. Morris shares with his readers the findings of the Fitch credit rating service from 2006 – that relied in turn on the banks which are the hedges prime brokers: “with Morgan Stanley, Goldman Sachs, JPMorgan Chase and Deutschebank topping most lists…hedge funds consistently pressure prime brokers for more leverage and easier credit so they can keep expanding positions…Although prime brokers are supposed to monitor their clients’ overall balance sheets and total margining, they concede that they typically do not have access to that information…Fitch concludes the survey by lamenting the ‘instability of hedge funds as an investor class,’ because of their reliance on short-term, margin-based lending,” (Morris, Pages 111-112.) And, he adds, high leverage.

Morris does a pretty good walk through on how leverage works for many hedges, especially the credit based ones, which have a leverage of about 5:1, using four dollars of borrowed money from their banks to every one dollar of their own investors’ capital. The example he gives on page 113 is of a hedge fund investing in a $2 billion collateralized debt obligation. Now I read this three times, the last time with a pen, pad and calculator in hand. Unfortunately, my calculator doesn’t handle billions. So it was back to pen and pad. Then the numbers rang true. The math isn’t hard – it’s just the context that is difficult for folks that don’t work these angles for a living. Here’s how it goes, a simple building block of the scary bigger matrix that lies at the heart of the speculative part of the financial system:

The hedge fund gets its initial capital for investing by selling shares to wealthy investors and then borrows $4 from its bank for every $1 of its members, creating that initial leverage of 5:1. In order to play in the CDO speculative market, the hedge fund needs to come up with $100 million to “control” that $2 billion CDO – so that leverage works out to be 20:1. But it only puts up $20 million of its own money – the rest, $80 million, it borrows from its partner bank. In Morris’ example, we’re talking bonds as the collateral, held by the bank in the margin account. He doesn’t say it, but I wondered whether the repo market we talked about above played a part? So what do we have here? An overall leverage of 5x20 or 100:1. Then, here’s the punch line and simultaneous worry: a loss of just 1% in the value of the $2 billion in CDO bonds wipes out all the equity put up by the hedge fund partners ($20 million: the missing math is .01 x $2,000,000,000 = $20 million). Morris then walks the reader through the consequences of a further 3% decline and 2% more on top of that – realistic re-enactment of many mortgage CDOs whose value continues to decline as house prices continue to fall. The bank asks for more collateral, the hedge fund turns its pockets inside-out and “the bank seizes assets and tries to sell them, and the doors blow off the market…” with the Bear Stearns disappearance illustrating “the balance of terror between the banks and their hedge fund clients.” (Page 116). And that’s why I call it a “journey to the financial heart of darkness.” And that’s how part of the “Great Unwinding” unfolds.

And just to help keep this journey in perspective, remember that back in my April 5, 2008 posting (“Leveraging the Laughs (and Tears) at Treasury”), I noted that the total of all derivative bets beings handled by JPMorgan Chase bank, according to federal reports, was $91.7 trillion, compared to the 2007 GDP of the entire US economy at $13.86 billion. The size of all the derivative bets, their “notional” value for the entire world financial system therefore runs to hundreds of trillions of dollars. Oops. Latest update now says it has passed a “quadrillion.” At http://www.jsmineset.com/ARhome.asp?VAfg=1&RQ=EDL,1&AR_T=1&GID=&linkid=6... [7] .

Here’s the heart of the matter for the math and grasping the way the “casino” works: hedge funds need big leverage because they’re not putting up much margin/capital of their own - $20 million in this case, the bank kicks in the rest – and yet the “notional” size of the bet is that $2 billion; that’s how swings of just 1-5% on that $2 billion investment quickly overwhelm “just” the tens of millions in capital/collateral. But don’t stop here. Listen to one of our authors, Mark Taylor (Confidence Games) who got the nature of what’s going on exactly right – way back in 2004. It’s the cumulative or “pyramiding” effect of many of these speculative building blocks that is the worry. He quotes from author John Geanakopolos, who was writing back even earlier, in 1997, and reproduces a chart showing houses on the ground, the physical reality, and “promises” to pay climbing up through three layers of the new financial instruments, the CMOs, the mortgage backed variety of CDOs: “ ‘Mortgage pass through securities offer a classical example of pyramiding. Pyramiding naturally gives rise to chain reactions, as a default by Mr. A ripples through, often all the way to D.’” Taylor adds that “at this point it becomes difficult to deny that the confidence game has become not only a casino but is actually a house of cards.” (Pages 178-179). Professor Taylor, now the Chairman of the Religion Department at Columbia University in New York, is not your average religion department chairman, having direct business experience of his own and Wall Street contacts that “allowed me (him) to look behind a curtain very few outsiders are allowed to lift.” The accuracy of his work, and the dates when he pulled it together, are a ringing answer to the question “Who Could Have Known?” and we’ll have more to say about his book in subsequent editions.

We should note also that one of the driving forces for higher and higher leverage among other types of hedge funds, specifically the ones pursuing “arbitrage” over small differences in interest rates or currency tracks, for example, is that the “spreads” or differences may be so small (compared to that $2 billion CDO investment) that the returns don’t work for investor expectations without the extraordinary leverage. (Thanks to Bookstaber, on this).

As a punctuation mark to this section, and this journey into our financial “heart of darkness,” we note the predicament of the monoline insurers, those entities like AMBAC and MBIA, which started out in the low-profit, sleepy investment world of insuring municipal bonds, but ended up, fittingly for this era, branching out to insure the hotter mortgage-backed CDOs. Morris observe that they “have written principal and interest insurance on about $3.3 trillion of instruments, on a collective capital base of only $22 billion, which is a leverage ratio of 150:1. Given the turmoil in CDOs, the monolines’ triple-A ratings at that level of leverage are absurd.” (Pages 123-124).

Indeed, Morris was right-on-the-money. On June 5, 2008 AMBAC and MBIA had their ratings cut down two levels from AAA, courtesy of Standard and Poor’s. According to Meredith Whitney, the analyst with Oppenheimer and Company who has been consistently on target with bold assessments of understated write-downs, there will be more big losses for Citigroup Inc., Merrill Lynch and Co. and UBS AG: “‘The limited earnings potential of monolines poses a risk to the value of the insurance and hedges on the subprime-related securities provided to the banks and brokers…The collateral damage could be in excess of an additional $10 billion.’” (My emphasis). From an article “Easing Swaps Risk, ‘Scarlet Letter,’ UBS: Compliance” by Lisa Brennan, June 10, 2008 at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=akfec3L0lX1U [8]

“The ultimate benefit…lower risks for all…”
Let’s close this section, Part I, with a paragraph that I wrote down when I began this journey in very early 2007. It’s from Timothy Geithner, the President of the Federal Reserve Bank of New York, and a key player in many of the current extraordinary efforts to keep the nation’s financial system from collapsing, including the efforts to “rescue” Bear Stearns in Mid-March of 2008. Now I don’t believe in making life for Mr.Geithner or Chairman Bernanke any more difficult than it already is at present: no one should wish to carry their burdens under the current situation, or add to them, a situation which just keeps getting more complex with the intense oil price spike and decline of the dollar. I put an explanation mark next to this passage – before any of the problems surfaced, because its assertions, made in 2006 to the Hong Kong Monetary Authority and Hong Kong Association of Bankers, were issued in the very late evening twilight of the likely end of an era, and I think it bears heavily the stamp of the hopes, dreams and illusions of that era, which events since August of 2007 have brought directly, in one way or another, to each of our homes. The speech is entitled: Hedge Funds and Derivatives and Their Implications for the Financial System. We might ask ourselves, however, at least one question, and keep it in mind, and we will explore what our authors have to say about it in the pending sections: how is it possible, in the world’s greatest democracy, now struggling also to remain its greatest economy, for those closest to its financial heart, to miss the dissenting voices?

So here it is, with only the comment that “arbitrage” means an investment or speculative play that is based on comparing the price differences between two or more assets: currencies, interest rates, or the market worth of companies…and buying them in one market and selling them in another…to reap the difference. Mark Taylor devotes a whole Chapter to a much broader meaning, called “Difference Engines,” to give you a sense of how important this idea became to many aspects of modern finance.

Here is President Geithner, in September of 2006:

In terms of enhancing overall market efficiency, the growth of these private leveraged institutions can be expected to provide benefits in terms of improved liquidity, price discovery via arbitrage, diversity of opinion and diversification opportunities for investors. The increase in the share of assets managed by private pools of capital devoted to arbitrage activity should improve the overall functioning of markets. In most circumstances, increased trading and participation contribute to market liquidity, and makes markets less volatile. The ultimate benefit should be lower risks for all market participants. This in turn should reduce the risk premia associated with holding financial assets, and ultimately reduce the cost of capital.

Although you might not realize it, if you’ve made it this far in our excursion, you should be able to make sense out of President Geithner’s address and judge for yourself whether he got the balance right between the needs of the speculative markets and the needs of the rest of our society.

The full text of his speech can be found at: http://www.ny.frb.org/newsevents/speeches/2006/gei060914.html [9]

Until Part II, I wish all my readers the very best,

Bill Neil
Rockville, MD