9.25.2008

"ESSE ET PERCIPI" or "AFTER THE RED PILL: HOW DEEP THE RABBIT HOLE GOES"

BY LUSCUS

That we have reached an economic crisis is agreed upon by all parties. Our financial system is sick; of this, there is no doubt. What is in dispute is the remedy. However, before the reader ambles forth in lyrical conjecture, we must first settle the facts. There are plentiful articles that offer condemnation of events yet to occur, without any consideration for diagnosis of the situation at hand, let alone divining its true cause. This is not one of them.

The Secretary of the Treasury, Henry Paulson, and the Chairman of the Federal Reserve, Benjamin Bernanke, have presented a joint appeal to Congress to approve a $700 billon dollar budget with which to purchase large swaths of mortgage-backed securities of questionable value. But "questionable" does not mean that they are of zero value; this is not a case of throwing good money after bad. Those mortgage-backed securities were not insured by, but the insurance for the credit-default swaps, and formed the foundation for the securitized assets which (to use yesterday's figures) now amount to some $50 trillion. What the treasury seeks to do is to replace the questionable anchor in the chain with one of hard currency. This would limit the value of the "questionable assets" to $700 billion at most. With more stable securitized assets, banks will no longer need to hoard funds, credit would begin to flow again, and we have limited the losses to $700 billion, and only in a doomsday scenario where every single item purchased defaults to zero. This is unlikely. For a great analysis of this, see the Chris Matthews interview of Jim Cramer and Steven Pearlstein
here.

Who, then, are the villains? It is easy to lump together "banks", "wall-street executives", and "speculators" into this role, but then we have done little more than create Hitler's Jew. Is it a crime to get rich? Is it criminal to accept multi-million dollar parachute clauses as terms for accepting a job? No, it is not. It is criminal, however, to present the false value of assets. This is called fraud. The reason the value of the anchors in the chain of collateralized-debt are questionable isn't because of speculation, excessive regulation, or excessive de-regulation: it's because 1) mortgage issuers were criminally negligent in processing mortgage applications, and 2) the function of the ratings agencies had been corrupted by collusion between its analysts and the issuers of the structured debt products. Lehmen Brothers, notorious for creating the most Byzantine products, has already faced the executioner. But this is a rare case of the punishment fitting the crime.

Capitalism and free-markets only work under the assumption of rational behavior. When markets act irrationally, as is the current case, the system allocates capital efficiently in neither the long term nor the short term, and fails in its raison d'tre. The whole system is founded on there being objective standards of measuring value. This standard has been called into question. Secretary Paulson's $700 billion dollar outlay would replace the questionable foundations with cold hard cash. But that won't mean a return to business as usual. Banks will have to unravel themselves from serious amounts of exposure, take moderate (but fair) losses, and restructure their entire risk-analysis models. This Christmas will be assuredly be dour for Manhattan's shops.

We now turn to the question of power, and whether this is an unholy expansion of government which will persist ad aeternum. This is putting the cart before the horse. It is highly doubtful that this or any Congress would hand over a blank check without conditions to the Secretary of the Treasury. There should indeed be conditions, but limited to these:

1. Time the office will exist for 9 months (three quarters), after which it will be terminated unless re-authorized by congress on a quarterly basis.
2. Scope the office to be established will exist solely for the purchase and eventual sale of distressed securities at the foundation of structured debt.
3. Statute of limitations the office to be established in the treasury is only to purchase securities issued on or before September 25th, 2008. This precludes the incentive for banks to continue issuing bad products.
4. Transparency - All efforts, purchases, or actions in the course of purchase must be recorded
5. Oversight actions will be monitored by a select group of appointed wise men (John McCain has suggested Warren Buffett, Michael Bloomberg, and Mitt Romney for roles in this, and I can't think of anyone more qualified)

The purchases should be made on one condition: full disclosure on the part of the seller. Any violation of this would be felonious. Attempts to impose salary restrictions or additional regulations on the sellers will only scare them away, and render this entire venture pointless.

This outlay is fundamentally necessary for America. We have the opportunity to eliminate over $49 trillion dollars of exposed risk, and hundreds of trillions in unknown and collateral risk in one fell swoop. While it would be nice for everyone to learn valuable lessons from this whole mess, the cost is unacceptable. If we fail to pass this outlay, or if congress attaches more strings than the above prescribed and causes it to fail, you will see not only banks fall, but the elimination of a nation's worth of pension and $401K plans (a boon for those of you who are comfortable with Social Security being the sole provider for all your needs in old-age), any and all health insurance companies (which would force national coverage by the government), the elimination of all savings over $100,000. The FDIC would be overwhelmed, and likely default, meaning that savings might not even then be safe. Without the prospect of future payments, the US would not only lose its credit rating, but bankrupt. The American dollar would fall to levels familiar only to Zimbabweans. It is hard to imagine this being an environment where civil society could survive, let alone flourish.

But this does not have to be so. We can shore up financial markets, re-establish the flow of credit, set a price floor for the housing markets, and begin to purge our system of the toxins that now threaten to kill their host. This is not a band-aid effort on the part of Mr. Paulson and Mr. Bernanke, nor is it the time to teach anyone a moral lesson. I urge you to call your representatives and demand that they support this endeavor.

3 comments:

Tony Cannizzaro said...

You are correct in the fundemental nature of this endeavour. It is, at heart, not explicitly an attempt to 'bailout' Wall Street and socialize the losses. It is meant to be a vehicle to ensure continued liquidity in our financial markets. The problem is, at least as of the past weeks scetchy-at-best releases of information regarding the form this will take, there are going to be a whole lot of ifs-ands-buts that coem attached to this. Losses WILL be socialized, instead of attempting to create a mechanism which encourages liquidity while ensuring the risk takers still assume the losses from their bad decisions. (Perhaps through, instead of an exchange of MBS for cash, an exchange for a pooled security which draws interest from the whole inventory of loans backing the securities purchased by the treasury. The treasury then sets a spot price at that for what it believes the losses will be on the collateral loans, so someone holding the new security can either buyout at a loss, or take their changes with the cash flows from the mortgages.)

Another "option" that Washington threw out there was the possibility of creating a repository for banks with high exposure that wanted "out". In "Lehman's" terms, these Banks could surrender control to the federal government and be let off the hook. This is perhaps the purest form of socialism that has been bandied about.

The other problem is that, as Hariolor expounded upon quite nicely, even with protections in place this sets a dangerous dangerous precedent. Quite simply, the government does not have the authority to do what it is doing, but its doing it anyway. Federalization in times of crisis will for now on be a credible option.

One ray of light that the democrats are trying to amend to the bill however is reformation of the new bankruptcy code. In the late 90's an obscure federal court opinion reversed decades of a common practice called "cramming down" a mortgage in bankruptcy. Through this action, judges reset the value of the debtor's obligation to the value of the house they are attempting to pay off (instead of the original loan price, which can often be a substantial difference). This provided a mechanism in the bankruptcy to adjust the value of the loans back down to the value of the assets colateralizing them, which helped mitigate some of the resultant pressures on home prices. (It is not coincidence in my opinion that the beginning of the housing bubble can be traced right back to the changing of this law).

Luscus, you may me right on with your FDIC comment... for those doubters, check out the following.

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=amZxIbcjZISU

Luscus said...

I'm not the champion of this position. That falls to guys like Henry Paulson, Ben Bernanke, Warren Buffett, and Jack Welch. If that group starts talking about the economy, you bet I'm going to sit up and pay attention.

For additional reading, as I think the Japanese recession of the 90s (known as the 'lost decade') is the best comparison for what's going on - although this occurrence for the US economy would set the planet back tremendously as a whole - see: http://www.prospect-magazine.co.uk/article_details.php?id=10363

This article really nails it when it comes to much of the corruption and collusion: http://www.ibdeditorials.com/IBDArticles.aspx?id=306978378974502

Jack Welch's statement can be found here: http://www.reuters.com/article/businessNews/idUSTRE48N74H20080924?feedType=RSS&feedName=businessNews&rpc=23&sp=true

Other good articles imho:

http://www.realclearmarkets.com/articles/2008/09/anatomy_of_an_economic_crisis.html

http://www.voxeu.org/index.php?q=node/1671

Hariolor said...

I don't doubt Jack and Ben and Harry are right about the ability of this to bring stability back to the street, but anyone who really believes in capitalism has to pause and ask why stability needs to be brought back with such a sweeping yet simultaneously pithy measure.

I appreciate the use of news articles to support position, and would point to this argument as particularly sanguine with regards to something you touched upon, luscus. Namely, that the boys in Washington want to set a bottom for these securities, a price that can be a starting-off point for determining some semblance of market value. Because let's admit it, the irrationality in the market is coming from a lack of information more than an outright panic.

Indeed, if instead of apportioning money to the problem, the Congress demanded that every investment bank, insurance firm, and holding company opened up their books and disclosed an itemized list of their assets with the purchase value and list of associated securities, there would be a mad frenzy of analysis followed by a rapid and decisive consolidation in the market. If everyone knew what the other guy had on his books, and could determine in some objective way how much of those assets was likely to go belly up, we'd see everything fix itself very quickly

The problem is, it's not PC, or politically popular to do this. People will lose money, some of them good, hardworking people. Credit will dry up almost completely - all the things I predict will come to pass...but that's capitalism, bitches. If we can put some blame on people who signed bad mortgages, or ran up their credit cards - if we can give a pat on the back to the short-sellers and CEOs who got out while there was money to be made - if we can champion those tenets of capitalism, we should be mature enough to accept that some of the fault for loss lies with people who own IRAs but don't know what's in their portfolio, or who work with an investment company but don't research its buying habits.

That is the real moral tragedy, here, this lays bare the cold, uncaring nature of capitalism at its best and, simultaneously, its worst. Lots of money can be made, lots of people can do better than they could ever dream of under any other system, but it can all go very wrong, and only those smart enough and rich enough to make it through the crisis will survive. Capitalism is the greatest tool a social darwinist can hope for, it truly sifts out the wise from the foolish, the weak from the strong. What makes us so afraid, though, is when we look in the mirror and realize we might be one of the ones chosen against. Then we plead for reason and cry about the irrational cruelty of a self-corrective market.

Take your red pill, America, and wake up cold and sick in a pod surrounded by your overlords. It's where you've been all along, the bubble you were in just made you believe things were A-OK.

Indeed, Luscus' metaphor is more apt than he may have even realized. The 90's and early 21st century were very much an economic Matrix, and now we're waking up, scared and alone, wondering how we're ever going to make things right again. The problem is, Paulson isn't Neo, he's Cypher. We know we aren't eating steak anymore, but we'll sell our souls to get the illusion of it.