Following an initial period of painful adaptation, we can live happily and healthily in a world with high energy costs
By Gregory Clark - Special To The Bee
Published 12:00 am PST Sunday, December 23, 2007
Oil prices have receded from their recent flirtation with $100 a barrel, but demand soars from China and India, rapidly industrializing countries with a massive energy thirst. The combination of increased demand, high prices and the prospect of an eventual peak in oil production, has caught Americans paralyzed between twin terrors: the fear that rampant consumption of oil and coal is irreversibly warming the Earth and the dread that without cheap oil our affluent lifestyles will evaporate.
Can't live with oil, can't live without it.
Study of the long economic history of the world suggests two things, however. Cheap fossil fuels actually explain little of how we got rich since the Industrial Revolution. And after an initial period of painful adaptation, we can live happily, opulently and indeed more healthily, in a world of permanent $100-a-barrel oil or even $500-a-barrel oil.
The first lesson of history is that cheap energy explains only a modest portion of our current wealth. We are now, as a result of the Industrial Revolution, 12 times richer than the average person in the pre-industrial world. Modern economic growth has been accompanied by huge declines in energy costs from exploiting coal and oil. A worker today can buy a gallon of gas with his wages from 20 minutes of work. Before the Industrial Revolution to buy the energy in a gallon of gas the English worker of the 1760s needed to work four hours.
As energy prices declined consumption rose. Currently in the United States we consume the equivalent in energy of six gallons of gas per person per day. In England in 1770 energy consumption (mainly coal) was equivalent to only 0.5 gallons of gas per day.
Many people think mistakenly that modern prosperity was founded on this fossil energy revolution, and that when the oil and coal is gone, it is back to the Stone Age. If we had no fossil energy, then we would be forced to rely on an essentially unlimited amount of solar power, available at five times current energy costs. With energy five times as expensive as at present we would take a substantial hit to incomes. Our living standard would decline by about 11 percent. But we would still be fantastically rich compared to the pre-industrial world.
That may seem like a lot of economic hurt, but put it in context. Our income would still be above the current living standards in Canada, Sweden or England. Oh, the suffering humanity! At current rates of economic growth we would gain back the income losses from having to convert to solar power in less than six years. And then onward on our march to ever greater prosperity.
The ability to sustain such high energy prices at little economic cost depends on the assumption that we can cut back from using the equivalent of six gallons of gas per person per day to 1.5 gallons. Is that really possible? The answer is that we know already it is.
The economy would withstand enormous increases in energy costs with modest damage because energy is even now so extravagantly cheap that most of it is squandered in uses of little value. Recently, I drove my 13-year-old son 230 miles round-trip from Davis to Chico, to play a 70-minute soccer game. Had every gallon of gas cost four hours of my wage, I am sure his team could have found opposition closer to home.
The median-sized U.S. home is now nearly 2,400 square feet, for an average family size of 2.6 people, almost 1,000 square feet per person. Much of that heated, air-conditioned and lighted square footage rarely gets used. Cities in the Central Valley, such as Elk Grove, that were developed in the world of cheap gas have sprawled across the landscape so that the only way to get to work or to shops is by car. Ninety-four percent of the inhabitants of Elk Grove drive to work. Sidewalks have disappeared in some locations.
Some countries in Europe, such as Denmark, which have by public policy made energy much more expensive, already use only the equivalent of about three gallons of gas per person. I have been to Copenhagen, and believe me the Danes are not suffering a lot from those the daily three gallons of gas they gave up.
But can we get down to 1.5 gallons without huge pain? We can see even now communities where for reasons of land scarcity people have been forced to adopt a lifestyle that uses much less energy – places like Manhattan, London or Singapore. Manhattan, for example, has 67,000 people per square mile. Kensington and Chelsea in London have 37,000 people per square mile. Housing space per person is much smaller, people walk or take public transit to work and to shop, and energy usage is correspondingly much lower, despite the inhabitants being very rich.
So the future after peak oil will involve living in such dense urban settings where destinations are walkable or bikeable, just as in pre-industrial cities (the city of London in 1801 had 100,000 inhabitants in one square mile). Homes will be much smaller, but instead of caverns of off-white sheet rock, we will spend our money in making much more attractive interiors. Nights will be darker. We will not have retail outlets lit up like the glare of the midday sun in Death Valley.
Such a lifestyle is not only possible it will be much healthier. We are not biologically adapted to the suburban lifestyle of Central California – lots of cheap calories delivered right to your seat in the SUV that shuttles you from your sofa at home, to your chair at work, to the gym where you try and work on your weight problem. It will also make aging more graceful. We now live as much in fear of losing our gas-fueled mobility as we age as we are of the Grim Reaper himself.
So life after peak oil should hold no terror for us – unless, of course, you have invested in a lot of suburban real estate.
24 December 2007
21 December 2007
The Catastrophist View
Peter Schiff is laughing at me. I’ve just asked him to entertain the following notion: that we dodged a bullet during August’s financial-market turmoil and, with the stock market bouncing right back from every dip, things might be okay. So why worry?
He stops laughing. “Why worry?” he asks. “Because we dodged a bullet but are about to step on a hand grenade.”
Sitting in a corner office of a nondescript building just off I-95 in Darien, Connecticut, Schiff, the president of brokerage Euro Pacific Capital, and author of Crash Proof: How to Profit From the Coming Economic Collapse, will spend the next hour spelling out a singularly pessimistic view of the American economy. And he will do so while exhibiting a curious juxtaposition unique to the bearish prognosticator: He speaks of disaster with a smile on his face. No, he’s not happy about our impending doom. But he is happy that people are finally taking him seriously.
Some people, anyway. The recessionary fears that were sparked by the global liquidity crisis in August have eased, largely because of a resilient stock market and a belief that the Federal Reserve’s interest-rate cut in September curtailed deeper losses. When Goldman Sachs invested in its own imploding Global Equity Opportunities hedge fund in August, calling it an “opportunity” and not a “rescue,” people laughed. Guess who laughed last? Goldman, which had reportedly enjoyed a $370 million gain on its $2 billion rescue by October. The optimists stay focused on stories like Steve Jobs’s next stroke of genius.
But Schiff, whom CNBC calls “Dr. Doom,” has not, as bears do when winter approaches, gone off to hide in a cave. Why not? Because every single one of the underlying economic factors that he has identified as cause for concern has worsened. And his is no longer a lone voice in the woods. If you don’t care to listen to a man nicknamed Dr. Doom, you can listen to people like former Federal Reserve chairman Alan Greenspan, esteemed bond-fund manager Bill Gross, or famed money manager Jeremy Grantham. They’re part of a growing chorus of voices that are saying many of the same things as Schiff.
Their bearish arguments come in many shapes and sizes, but here’s the basic one: The past five or six years have been deceptively fortunate ones for the U.S. economy. That’s because any troublesome developments—the surge in oil prices from $28 per barrel in 2003 to about $87 today, for example—have been papered over by rising home prices. Home equity has been used to buy flat-screen TVs, SUVs, and more homes. Wall Street bought up all this debt from lenders, thereby allowing them to lend more.
The softening of real-estate prices in most parts of the United States put a crimp in this system, but it hasn’t stopped it. The question is, what, if anything, will? What will bring on the apocalypse that Schiff and others believe is inevitable? They see it like this:
THREAT NO. 1
The Bottom Continues to Fall Out of the Housing Market
Manhattan’s gravity-defying real estate aside, it’s quite clear the nation is experiencing a genuine housing crisis. In August, pending home sales dropped 6.5 percent, and they currently sit at their lowest level since 2001. The National Association of Realtors conducted a recent survey that showed more than 10 percent of sales contracts fell through at the last moment in August, primarily owing to disappearing loan commitments from banks. The crisis will only deepen, when more borrowers see their adjustable-rate mortgages adjusted upward. There was a foreclosure filing for one of every 510 households in the country in August, the highest figure ever issued, and by one estimate, more than 1.7 million foreclosures will occur in the country by the end of 2008. That’s not just subprime borrowers: According to the Federal Housing Finance Board, while nearly 35 percent of conventional mortgages in 2004 used ARMs, some 70.7 percent of jumbo loans—those above $333,700 (the jumbo threshold in 2004; it’s now higher)—did too.
Historically, bond-market investors have been the boring counterparts to their equity-market brethren. But in his October Investment Outlook, famed bond investor Bill Gross was anything but. The managing director of money management firm pimco pointed out that the Federal Reserve is caught in a bind: It must continue to lower interest rates to ameliorate this burgeoning housing crisis, but in doing so, it “risks reigniting speculative equity market behavior, and … a run on the dollar.” (More on the dollar later.) Gross doesn’t have the answers but observes that the Fed is “in a pickle, and a sour one at that.” Worse yet, concerns that a rate cut might be inflationary actually caused bond yields to rise in the wake of the rate cut, something that doesn’t normally happen. The Fed’s influence, always overstated, might turn out to be nonexistent in a credit market that remains on edge.
Hedge-fund veteran Rick Bookstaber, the author of A Demon of Our Own Design, spells out a potentially disastrous scenario that could unfold regardless of what the Fed does: Continued foreclosures result in a further drop in housing prices, which results in further foreclosures, which result in a further drop in housing prices. Even for those of us not selling, reduced home values result in a reduced sense of security, which results in reduced consumption, which results in a slowing economy, which … you get the point.
Next: The derivatives-related meltdown, part II.
THREAT NO. 2
The Derivatives-Related Meltdown, Part II
Anybody who glances occasionally at the financial pages these days knows that mortgages issued to home buyers are packaged together (in a process called securitization) into a collateralized-debt obligation, or CDO. That’s what’s known as a derivative, a security whose value depends on the value of other securities. The price of the CDO, you see, is “derived” from the prices of the underlying mortgages. (It works with credit cards, too, or bank loans—any kind of debt will do.)
In principle, the idea of a CDO makes perfect sense. In buying $5 million worth of a CDO, an investor has essentially lent money to an entire portfolio of homeowners, instead of placing all his eggs in one basket, say, by funding a single $5 million mortgage. In the real-estate-crazy environment of the past decade, the CDO market took off like a rocket. But the buyers of these derivatives made a critical error—they confused the spreading of risk with the elimination of risk. A booming economy made this confusion not just possible but irresistible. With relatively few defaults in the first half of the decade, investment firms, including many hedge funds, came to see CDO returns as a sure thing and loaded up on them, often borrowing money to do so, taking on debt to buy debt and thereby setting up a potentially deadly chain reaction. The readiness of the secondary market to buy all these mortgages encouraged the lenders to run wild and lend to anyone who walked through the door, leading—inevitably, in retrospect—to a decline in loan quality. Analyst Christopher Wood of Asia-Pacific investment house CLSA succinctly defines the problem in his highly readable newsletter Greed & Fear: “[Securitization] has one fatal flaw, which will ultimately prove to be its undoing … it removes the incentive of those making the loan to worry about whether the loan is a good credit.”
Still, it all held together until mortgage defaults began to cut into the yields of these CDOs and holders looked to sell them, only to realize their value had slipped. Forced liquidations as a result of that “price discovery” were a primary factor in Bear Stearns’ hedge-fund calamity in August. And it’s not over yet: The aftershocks of the mortgage meltdown are still being felt, as banks such as Citigroup and Deutsche Bank announce multibillion-dollar write-downs.
Each time one of these write-downs has been announced, the market has had a curiously positive response, taking the news as a sign that the worst was over and the banks were cleaning up their books. But because these derivatives are linked to other debt, there’s no reason to be certain that trouble won’t bleed into other markets. Among other things, the liquidity crisis froze the market in structured investment vehicles (SIVs), a nifty bit of financial engineering that banks use to profit from the spread between short-term debt and long-term debt. No one yet knows how nasty these losses could turn out to be because SIVs are stashed, Enron style, off the books.
THREAT NO. 3
Consumers Run Out of Steam (and Take the Economy Down With Them)
The U.S. economy, for all its worldly sophistication, is driven by mall shoppers and late-night Amazon addicts—70 percent of the gross domestic product is accounted for by consumer spending, which is buttressed by debt. According to the Federal Reserve, total U.S. household debt was, as of August, $2.5 trillion—a 24 percent increase in the past five years. Total credit-card debt, including gas cards and the like, was $915 billion.
The willingness of consumers to keep spending and piling on debt in the midst of a slowing real-estate market is hailed on Wall Street as an act of patriotism, which Schiff considers perverse. Imagine, he suggests, that you ran into a good friend and asked him how he was doing. His reply: “I took out a third mortgage, maxed out my credit cards, and emptied out my kids’ college savings account so I could buy a bigger TV and a new car, and we’re going to Greece on vacation over the holidays. Things are great!” Schiff lets the idea sink in and then finishes the thought: “And we’re celebrating the fact that we’re doing this as a nation?”
Next: The dollar tumbles hard.
In a recent interview, John Santer, a district director of NeighborWorks America, a community-based nonprofit, pointed out that 43 percent of American households spend more than they earn each year, and fewer than six in ten have enough savings to last them three months if they were suddenly out of a job. So where’s the money coming from? From 1991 to 2005, Americans borrowed $530 billion against the value of their homes each year.
James Glassman, a senior economist at JPMorgan Chase, told a Tulsa, Oklahoma, luncheon crowd in early October that before 1985, consumer spending grew in line with income, but since that time, it’s grown half a percent faster on an annual basis. As a result, household savings, which once reached 10 percent of income, is now literally negative. “My guess is that in five years we’ll look back and realize … that the consumer we knew for twenty years is coming to an end,” he said.
Roger Ehrenberg, an ex–Wall Streeter and author of the financial blog Information Arbitrage, forecasts extreme financial pain. “You’ve got a weaker dollar, declining economic fundamentals, and a debt-strapped consumer—I’d call that a bad fact set,” he says. “Lay on top of that the mortgage problem and declining home values, and you can paint a pretty ugly picture.”
THREAT NO. 4
That the Rest of the World Decides They Don’t Need Us and the Dollar Tumbles Hard
The dollar is falling, possibly collapsing, depending on whom you talk to. The greenback has sunk close to its lowest point in the post-1973 floating-exchange-rate era, so low that it’s been overtaken by the Canadian dollar—affectionately known as the loonie—for the first time since 1976. How low will it go? When Alan Greenspan was asked by Lesley Stahl of 60 Minutes last month what currency he’d like to be paid in, his response was telling: “[The] key question … is, ‘In what currency do you wish to hold your assets?’ And what I’ve done is I diversify.” Translation: He isn’t betting on the dollar. And neither is the majority of Wall Street.
Here’s why catastrophists see that as a major problem: About 25 percent of our government debt is held by foreign governments, with the major holders being Japan ($610.9 billion), China ($407.8 billion), the U.K. ($210.1 billion), and our friends in the Middle East, the oil-exporting countries ($123.8 billion). When the current Fed chairman, Ben Bernanke, cuts rates to soften the housing blow for Americans, he also weakens the dollar by making dollar-based investments less attractive. And when the dollar weakens, so, too, does the value of these gigantic positions held by the foreign governments. At some point, they’re no longer going to tolerate the losses we inflict on them by lowering rates, and if that happens and they start dumping dollars, watch out for the peso.
The bulls will tell you that foreign governments understand the American economy is the key to global economic health, and that they’ll suck it up and take it when we devalue their debt. To which Schiff offers another analogy. Imagine if five people were washed up on a desert island: four Asians and an American. In splitting up their duties, one Asian says he’ll fish; another will hunt, another will look for firewood, and another will cook. The American assigns himself the job of eating.
“The modern economist looks at this situation and says the American is key to the whole thing,” says Schiff. “Because without him to eat, the four Asians would be unemployed.” The alternative: Without the American, the Asians might eat a little more themselves and even spend some time building a boat. This is happening as we speak: With the rise of the Chinese consumer class, the local citizenry is now spending, and the country is no longer totally dependent on exports. Which means they’re no longer totally dependent on us.
Readers of the financial press are surely familiar with the buzzword of the moment, decoupling. It’s used to describe how U.S.-Europe and U.S.-Asian trade relationships are becoming less dependent at the same time as European-Asian ties are growing. Most Asian nations, including China, are seeing more rapid growth in exports to Europe than to the U.S. And the U.S. now accounts for a declining share of European exports. The bearish interpretation: that the longtime global embrace of the dollar is loosening.
Next: We don’t see it happening because it’s a slow-motion train wreck.
THREAT NO. 5
That We Don’t See It Happening Because It’s a Slow-Motion Train Wreck
Last but not least, we can circle back to the Dow Jones Industrial Average making new highs in October—14,087.55 on October 1—offering hope that our equity portfolios will carry us through to the other side of whatever it is we’re on the wrong side of. Before addressing the fact that the equity market might just be clueless, there’s one last dollar-related point to make. The true value of a stock portfolio isn’t really its quoted worth in dollars—it’s what you could buy with that portfolio if you were to sell it.
Given that we as Americans don’t manufacture that much anymore (we’re a service economy!), we are largely talking about foreign-made goods, such as flat-screens from Korea or cars from Germany. Over time, if the dollar continues to slump, foreign manufacturers will raise prices to compensate for what they’re losing in the exchange rate. In that light, a Dow at 14,000 with the euro at $1.42 is really no different from a Dow at 13,000 with the euro at $1.33. (One reason the price of oil has risen so high is that it is quoted in dollars, and the sellers thereof have had to continually jack up the per-barrel price to maintain their own purchasing power at home and elsewhere.)
Still, a rising Dow is better than a falling Dow, and the bulls are piling into every rally. Which still doesn’t impress Jeremy Grantham, chairman of Boston-based money manager GMO, in the least. “The equity market is always slow to pick up on someone else’s crisis,” he says, referring to the turmoil in both the housing and fixed-income markets. “And so you’ve got a slow-motion train wreck that has to work itself through the system.”
How will it work itself through? Grantham points to the recent strength in profit margins, fueled by—you guessed it!—our plummeting savings rate, and says there’s nowhere to go but down. “If you start with an overpriced market and bring profit margins down, that’s more than enough to bring stock prices down,” he says. “It is the most certain mean-reversion in all of finance.” Grantham calculates that the U.S. stock market will have to fall by a full third before it gets to its “fair value.” At which point we will likely be in full-blown recession. And when that happens, Schiff says, we will see a country in downsizing mode, “selling the consumer goods we’ve been buying back to the Chinese. It will be one big, giant repossession.”
So assuming all this is true, that Schiff and his fellow doomsayers are right about the rotten core of the U.S. economy, how will this affect New York City? We’ve grown accustomed to the idea of our local economy, particularly the real-estate market, being inherently stronger than the nation’s and possibly immune to whatever woes strike the rest of America. Wall Street, after all, makes money on downs as well as ups, and the stampede of foreigners and foreign cash could, if anything, be aided by the weak dollar.
Last week, though, the argument against New York invincibility was implicitly made when Merrill Lynch announced a larger-than-expected write-down of $7.9 billion dollars in its third quarter alone, primarily due to losses in the credit markets. Numbers as large as that can paradoxically seem trivial due to the abstract nature of accounting—a “write-down” involves no movement of real-life cash, just a readjustment of some theoretical values—but here’s something nontrivial to consider: Merrill Lynch is one of the largest employers in New York City. While so far only a few Merrill bigwigs have been shown the door, it’s almost certain that a chunk of the company’s rank and file will soon follow. All told, New York–based financial companies had already announced more than 42,000 layoffs as of October, according to one study, and the pace could pick up through the end of the year. That’s people who won’t be bidding up new apartments, who won’t be going out to dinner five times a week, who won’t be testing the outer limits of their credit cards at Barneys. The downstream effects of this could be even more severe, as every Wall Street job is estimated to account for another 1.3 to 2 jobs, meaning that additional job losses could push 100,000.
Meanwhile, the public sector is feeling it, too. A recent report by Nicole Gelinas, published by the Manhattan Institute, forecast a budget deficit for New York City next year and predicted that Mayor Bloomberg, who enjoyed a string of budget surpluses until this year, will likely be forced to leave his successor with a double whammy: a deficit and a projected 50 percent increase in outstanding debt. Of course, the catastrophists could be dead wrong, as they have been for going on a decade now—but to them, it sure smells like the seventies all over again.
Next: Good-Behavior Bribes for the Poor?
He stops laughing. “Why worry?” he asks. “Because we dodged a bullet but are about to step on a hand grenade.”
Sitting in a corner office of a nondescript building just off I-95 in Darien, Connecticut, Schiff, the president of brokerage Euro Pacific Capital, and author of Crash Proof: How to Profit From the Coming Economic Collapse, will spend the next hour spelling out a singularly pessimistic view of the American economy. And he will do so while exhibiting a curious juxtaposition unique to the bearish prognosticator: He speaks of disaster with a smile on his face. No, he’s not happy about our impending doom. But he is happy that people are finally taking him seriously.
Some people, anyway. The recessionary fears that were sparked by the global liquidity crisis in August have eased, largely because of a resilient stock market and a belief that the Federal Reserve’s interest-rate cut in September curtailed deeper losses. When Goldman Sachs invested in its own imploding Global Equity Opportunities hedge fund in August, calling it an “opportunity” and not a “rescue,” people laughed. Guess who laughed last? Goldman, which had reportedly enjoyed a $370 million gain on its $2 billion rescue by October. The optimists stay focused on stories like Steve Jobs’s next stroke of genius.
But Schiff, whom CNBC calls “Dr. Doom,” has not, as bears do when winter approaches, gone off to hide in a cave. Why not? Because every single one of the underlying economic factors that he has identified as cause for concern has worsened. And his is no longer a lone voice in the woods. If you don’t care to listen to a man nicknamed Dr. Doom, you can listen to people like former Federal Reserve chairman Alan Greenspan, esteemed bond-fund manager Bill Gross, or famed money manager Jeremy Grantham. They’re part of a growing chorus of voices that are saying many of the same things as Schiff.
Their bearish arguments come in many shapes and sizes, but here’s the basic one: The past five or six years have been deceptively fortunate ones for the U.S. economy. That’s because any troublesome developments—the surge in oil prices from $28 per barrel in 2003 to about $87 today, for example—have been papered over by rising home prices. Home equity has been used to buy flat-screen TVs, SUVs, and more homes. Wall Street bought up all this debt from lenders, thereby allowing them to lend more.
The softening of real-estate prices in most parts of the United States put a crimp in this system, but it hasn’t stopped it. The question is, what, if anything, will? What will bring on the apocalypse that Schiff and others believe is inevitable? They see it like this:
THREAT NO. 1
The Bottom Continues to Fall Out of the Housing Market
Manhattan’s gravity-defying real estate aside, it’s quite clear the nation is experiencing a genuine housing crisis. In August, pending home sales dropped 6.5 percent, and they currently sit at their lowest level since 2001. The National Association of Realtors conducted a recent survey that showed more than 10 percent of sales contracts fell through at the last moment in August, primarily owing to disappearing loan commitments from banks. The crisis will only deepen, when more borrowers see their adjustable-rate mortgages adjusted upward. There was a foreclosure filing for one of every 510 households in the country in August, the highest figure ever issued, and by one estimate, more than 1.7 million foreclosures will occur in the country by the end of 2008. That’s not just subprime borrowers: According to the Federal Housing Finance Board, while nearly 35 percent of conventional mortgages in 2004 used ARMs, some 70.7 percent of jumbo loans—those above $333,700 (the jumbo threshold in 2004; it’s now higher)—did too.
Historically, bond-market investors have been the boring counterparts to their equity-market brethren. But in his October Investment Outlook, famed bond investor Bill Gross was anything but. The managing director of money management firm pimco pointed out that the Federal Reserve is caught in a bind: It must continue to lower interest rates to ameliorate this burgeoning housing crisis, but in doing so, it “risks reigniting speculative equity market behavior, and … a run on the dollar.” (More on the dollar later.) Gross doesn’t have the answers but observes that the Fed is “in a pickle, and a sour one at that.” Worse yet, concerns that a rate cut might be inflationary actually caused bond yields to rise in the wake of the rate cut, something that doesn’t normally happen. The Fed’s influence, always overstated, might turn out to be nonexistent in a credit market that remains on edge.
Hedge-fund veteran Rick Bookstaber, the author of A Demon of Our Own Design, spells out a potentially disastrous scenario that could unfold regardless of what the Fed does: Continued foreclosures result in a further drop in housing prices, which results in further foreclosures, which result in a further drop in housing prices. Even for those of us not selling, reduced home values result in a reduced sense of security, which results in reduced consumption, which results in a slowing economy, which … you get the point.
Next: The derivatives-related meltdown, part II.
THREAT NO. 2
The Derivatives-Related Meltdown, Part II
Anybody who glances occasionally at the financial pages these days knows that mortgages issued to home buyers are packaged together (in a process called securitization) into a collateralized-debt obligation, or CDO. That’s what’s known as a derivative, a security whose value depends on the value of other securities. The price of the CDO, you see, is “derived” from the prices of the underlying mortgages. (It works with credit cards, too, or bank loans—any kind of debt will do.)
In principle, the idea of a CDO makes perfect sense. In buying $5 million worth of a CDO, an investor has essentially lent money to an entire portfolio of homeowners, instead of placing all his eggs in one basket, say, by funding a single $5 million mortgage. In the real-estate-crazy environment of the past decade, the CDO market took off like a rocket. But the buyers of these derivatives made a critical error—they confused the spreading of risk with the elimination of risk. A booming economy made this confusion not just possible but irresistible. With relatively few defaults in the first half of the decade, investment firms, including many hedge funds, came to see CDO returns as a sure thing and loaded up on them, often borrowing money to do so, taking on debt to buy debt and thereby setting up a potentially deadly chain reaction. The readiness of the secondary market to buy all these mortgages encouraged the lenders to run wild and lend to anyone who walked through the door, leading—inevitably, in retrospect—to a decline in loan quality. Analyst Christopher Wood of Asia-Pacific investment house CLSA succinctly defines the problem in his highly readable newsletter Greed & Fear: “[Securitization] has one fatal flaw, which will ultimately prove to be its undoing … it removes the incentive of those making the loan to worry about whether the loan is a good credit.”
Still, it all held together until mortgage defaults began to cut into the yields of these CDOs and holders looked to sell them, only to realize their value had slipped. Forced liquidations as a result of that “price discovery” were a primary factor in Bear Stearns’ hedge-fund calamity in August. And it’s not over yet: The aftershocks of the mortgage meltdown are still being felt, as banks such as Citigroup and Deutsche Bank announce multibillion-dollar write-downs.
Each time one of these write-downs has been announced, the market has had a curiously positive response, taking the news as a sign that the worst was over and the banks were cleaning up their books. But because these derivatives are linked to other debt, there’s no reason to be certain that trouble won’t bleed into other markets. Among other things, the liquidity crisis froze the market in structured investment vehicles (SIVs), a nifty bit of financial engineering that banks use to profit from the spread between short-term debt and long-term debt. No one yet knows how nasty these losses could turn out to be because SIVs are stashed, Enron style, off the books.
THREAT NO. 3
Consumers Run Out of Steam (and Take the Economy Down With Them)
The U.S. economy, for all its worldly sophistication, is driven by mall shoppers and late-night Amazon addicts—70 percent of the gross domestic product is accounted for by consumer spending, which is buttressed by debt. According to the Federal Reserve, total U.S. household debt was, as of August, $2.5 trillion—a 24 percent increase in the past five years. Total credit-card debt, including gas cards and the like, was $915 billion.
The willingness of consumers to keep spending and piling on debt in the midst of a slowing real-estate market is hailed on Wall Street as an act of patriotism, which Schiff considers perverse. Imagine, he suggests, that you ran into a good friend and asked him how he was doing. His reply: “I took out a third mortgage, maxed out my credit cards, and emptied out my kids’ college savings account so I could buy a bigger TV and a new car, and we’re going to Greece on vacation over the holidays. Things are great!” Schiff lets the idea sink in and then finishes the thought: “And we’re celebrating the fact that we’re doing this as a nation?”
Next: The dollar tumbles hard.
In a recent interview, John Santer, a district director of NeighborWorks America, a community-based nonprofit, pointed out that 43 percent of American households spend more than they earn each year, and fewer than six in ten have enough savings to last them three months if they were suddenly out of a job. So where’s the money coming from? From 1991 to 2005, Americans borrowed $530 billion against the value of their homes each year.
James Glassman, a senior economist at JPMorgan Chase, told a Tulsa, Oklahoma, luncheon crowd in early October that before 1985, consumer spending grew in line with income, but since that time, it’s grown half a percent faster on an annual basis. As a result, household savings, which once reached 10 percent of income, is now literally negative. “My guess is that in five years we’ll look back and realize … that the consumer we knew for twenty years is coming to an end,” he said.
Roger Ehrenberg, an ex–Wall Streeter and author of the financial blog Information Arbitrage, forecasts extreme financial pain. “You’ve got a weaker dollar, declining economic fundamentals, and a debt-strapped consumer—I’d call that a bad fact set,” he says. “Lay on top of that the mortgage problem and declining home values, and you can paint a pretty ugly picture.”
THREAT NO. 4
That the Rest of the World Decides They Don’t Need Us and the Dollar Tumbles Hard
The dollar is falling, possibly collapsing, depending on whom you talk to. The greenback has sunk close to its lowest point in the post-1973 floating-exchange-rate era, so low that it’s been overtaken by the Canadian dollar—affectionately known as the loonie—for the first time since 1976. How low will it go? When Alan Greenspan was asked by Lesley Stahl of 60 Minutes last month what currency he’d like to be paid in, his response was telling: “[The] key question … is, ‘In what currency do you wish to hold your assets?’ And what I’ve done is I diversify.” Translation: He isn’t betting on the dollar. And neither is the majority of Wall Street.
Here’s why catastrophists see that as a major problem: About 25 percent of our government debt is held by foreign governments, with the major holders being Japan ($610.9 billion), China ($407.8 billion), the U.K. ($210.1 billion), and our friends in the Middle East, the oil-exporting countries ($123.8 billion). When the current Fed chairman, Ben Bernanke, cuts rates to soften the housing blow for Americans, he also weakens the dollar by making dollar-based investments less attractive. And when the dollar weakens, so, too, does the value of these gigantic positions held by the foreign governments. At some point, they’re no longer going to tolerate the losses we inflict on them by lowering rates, and if that happens and they start dumping dollars, watch out for the peso.
The bulls will tell you that foreign governments understand the American economy is the key to global economic health, and that they’ll suck it up and take it when we devalue their debt. To which Schiff offers another analogy. Imagine if five people were washed up on a desert island: four Asians and an American. In splitting up their duties, one Asian says he’ll fish; another will hunt, another will look for firewood, and another will cook. The American assigns himself the job of eating.
“The modern economist looks at this situation and says the American is key to the whole thing,” says Schiff. “Because without him to eat, the four Asians would be unemployed.” The alternative: Without the American, the Asians might eat a little more themselves and even spend some time building a boat. This is happening as we speak: With the rise of the Chinese consumer class, the local citizenry is now spending, and the country is no longer totally dependent on exports. Which means they’re no longer totally dependent on us.
Readers of the financial press are surely familiar with the buzzword of the moment, decoupling. It’s used to describe how U.S.-Europe and U.S.-Asian trade relationships are becoming less dependent at the same time as European-Asian ties are growing. Most Asian nations, including China, are seeing more rapid growth in exports to Europe than to the U.S. And the U.S. now accounts for a declining share of European exports. The bearish interpretation: that the longtime global embrace of the dollar is loosening.
Next: We don’t see it happening because it’s a slow-motion train wreck.
THREAT NO. 5
That We Don’t See It Happening Because It’s a Slow-Motion Train Wreck
Last but not least, we can circle back to the Dow Jones Industrial Average making new highs in October—14,087.55 on October 1—offering hope that our equity portfolios will carry us through to the other side of whatever it is we’re on the wrong side of. Before addressing the fact that the equity market might just be clueless, there’s one last dollar-related point to make. The true value of a stock portfolio isn’t really its quoted worth in dollars—it’s what you could buy with that portfolio if you were to sell it.
Given that we as Americans don’t manufacture that much anymore (we’re a service economy!), we are largely talking about foreign-made goods, such as flat-screens from Korea or cars from Germany. Over time, if the dollar continues to slump, foreign manufacturers will raise prices to compensate for what they’re losing in the exchange rate. In that light, a Dow at 14,000 with the euro at $1.42 is really no different from a Dow at 13,000 with the euro at $1.33. (One reason the price of oil has risen so high is that it is quoted in dollars, and the sellers thereof have had to continually jack up the per-barrel price to maintain their own purchasing power at home and elsewhere.)
Still, a rising Dow is better than a falling Dow, and the bulls are piling into every rally. Which still doesn’t impress Jeremy Grantham, chairman of Boston-based money manager GMO, in the least. “The equity market is always slow to pick up on someone else’s crisis,” he says, referring to the turmoil in both the housing and fixed-income markets. “And so you’ve got a slow-motion train wreck that has to work itself through the system.”
How will it work itself through? Grantham points to the recent strength in profit margins, fueled by—you guessed it!—our plummeting savings rate, and says there’s nowhere to go but down. “If you start with an overpriced market and bring profit margins down, that’s more than enough to bring stock prices down,” he says. “It is the most certain mean-reversion in all of finance.” Grantham calculates that the U.S. stock market will have to fall by a full third before it gets to its “fair value.” At which point we will likely be in full-blown recession. And when that happens, Schiff says, we will see a country in downsizing mode, “selling the consumer goods we’ve been buying back to the Chinese. It will be one big, giant repossession.”
So assuming all this is true, that Schiff and his fellow doomsayers are right about the rotten core of the U.S. economy, how will this affect New York City? We’ve grown accustomed to the idea of our local economy, particularly the real-estate market, being inherently stronger than the nation’s and possibly immune to whatever woes strike the rest of America. Wall Street, after all, makes money on downs as well as ups, and the stampede of foreigners and foreign cash could, if anything, be aided by the weak dollar.
Last week, though, the argument against New York invincibility was implicitly made when Merrill Lynch announced a larger-than-expected write-down of $7.9 billion dollars in its third quarter alone, primarily due to losses in the credit markets. Numbers as large as that can paradoxically seem trivial due to the abstract nature of accounting—a “write-down” involves no movement of real-life cash, just a readjustment of some theoretical values—but here’s something nontrivial to consider: Merrill Lynch is one of the largest employers in New York City. While so far only a few Merrill bigwigs have been shown the door, it’s almost certain that a chunk of the company’s rank and file will soon follow. All told, New York–based financial companies had already announced more than 42,000 layoffs as of October, according to one study, and the pace could pick up through the end of the year. That’s people who won’t be bidding up new apartments, who won’t be going out to dinner five times a week, who won’t be testing the outer limits of their credit cards at Barneys. The downstream effects of this could be even more severe, as every Wall Street job is estimated to account for another 1.3 to 2 jobs, meaning that additional job losses could push 100,000.
Meanwhile, the public sector is feeling it, too. A recent report by Nicole Gelinas, published by the Manhattan Institute, forecast a budget deficit for New York City next year and predicted that Mayor Bloomberg, who enjoyed a string of budget surpluses until this year, will likely be forced to leave his successor with a double whammy: a deficit and a projected 50 percent increase in outstanding debt. Of course, the catastrophists could be dead wrong, as they have been for going on a decade now—but to them, it sure smells like the seventies all over again.
Next: Good-Behavior Bribes for the Poor?
14 December 2007
Financial Evolution - brilliant stuff!!!
“Just as some species become extinct in nature, some new financing techniques may prove to be less successful than others.”
The remark was made to the US Congress in September by Anthony Ryan, assistant Treasury secretary. Only when we know the true magnitude of the current financial crisis will we be able fully to appreciate the significance of his words.
Analogies between finance and evolution are in themselves nothing new. “The survival of the fittest” is a phrase that aggressive traders like to use. “It’s Darwinian out there” is a stock utterance by hedge fund managers after an especially tough week. Back in November 2005, a conference hosted by Goldman Sachs, the investment bank, was entitled “The Evolution of Excellence”.
Yet, as became clear at that gathering, when financial practitioners use such terms they seldom understand just how apposite they are. A long-run historical analysis of the development of financial services, going all the way back to the days of Charles Darwin, strongly suggests that evolutionary forces are as much at work in the realm of money as they are in the natural world.
The big question for our time is: are we on the brink of a “great dying” – one of those mass extinctions of species that have occurred periodically in the history of life on earth, such as the Cretaceous-Tertiary crisis that killed off the dinosaurs? It is a scenario that many biologists have reason to fear, as man-made climate change wreaks havoc with natural habitats around the globe. A great dying is also a scenario that financial analysts should worry about, as another man-made disaster – the subprime mortgage crisis – works its way through the global financial system.
★ ★ ★
The notion that Darwinian processes may be at work in the economy was raised by Thorstein Veblen, the Norwegian-American economist best known for his Theory of the Leisure Class, as long ago as 1898. There has been an academic journal devoted to the subject for the past 16 years, though most economists remain sceptical about the applicability of Darwin’s ideas in the economic sphere. The analogy is in fact surprisingly good in the case of the financial services industry, which has many of the defining characteristics of a true evolutionary system:
●“Genes”, in the sense that certain business practices perform the same role as genes in biology, allowing information to be stored in the “organisational memory” and passed on from individual to individual or from company to company when a new one is created.
●The potential for spontaneous “mutation”, usually referred to in the economic world as innovation and primarily, though by no means always, technological.
●Competition among individuals within a species for resources, with the outcomes in terms of longevity and proliferation determining which business practices persist.
●A mechanism for natural selection through the market allocation of capital and human resources and the possibility of death in cases of underperformance, in other words “differential survival”.
●Scope for “speciation”, sustaining biodiversity through the creation of wholly new “species” of financial institutions.
●Scope for extinction, with species dying out altogether.
Financial history is essentially the result of institutional mutation and natural selection. Random “drift” (innovations/mutations that are not promoted by natural selection, but just happen) and “flow” (innovations/mutations that are caused when, say, American practices are adopted by Chinese banks) play a part. There can also be “co-evolution”, when different financial species work and adapt together (like hedge funds and their prime brokers).
But market selection is the main driver. Financial organisms are in competition with one another for finite resources. At certain times and in certain places, certain species may become dominant. But innovations by competitor species, or the emergence of altogether new species, prevent any permanent hierarchy or monoculture from emerging. Broadly speaking, the law of the “survival of the fittest” applies. Institutions with a “selfish gene” that is good at self-replication (and self-perpetuation) will tend to endure and proliferate.
The analogy is, of course, not perfect. When one organism ingests another in the natural world, it is just eating, whereas in financial services mergers and acquisitions can lead directly to mutation. Among financial organisms, there is no counterpart to the role of sexual reproduction. Most financial mutation is deliberate, conscious innovation rather than random change. Indeed, because a company can adapt within its own lifetime to change going on around it, financial evolution (like cultural evolution) may be best described not as Darwinian but Lamarckian, after the French biologist who contended that an individual organism could acquire new and heritable traits. Still, the resemblances outnumber the differences – and evolution certainly offers a better model for understanding financial change than any other we have.
Rudolf Hilferding, the German socialist, a century ago predicted an inexorable movement towards more concentration of ownership in “financial capitalism”. The conventional view of financial development does indeed see the process from the vantage point of the big survivor. In the successful company’s official “family tree”, numerous small companies are seen to converge over time on a common “trunk”, the present-day conglomerate – the kind of giant “überbank” that Hilferding imagined would ultimately take over the entire financial system. However, this is precisely the wrong way to think about financial evolution. Over the long run, financial innovation begins at a common trunk. Over time, the trunk branches outwards as new kinds of bank and other financial institution evolve. The fact that a particular institution successfully devours smaller rivals along the way is more or less irrelevant. In the evolutionary process, animals eat one another, but that is not the driving force behind evolutionary mutation and the emergence of new species and sub-species.
The point is that economies of scale and scope are not always the driving force in financial history. More often, the real drivers are the process of speciation – when new types of company are created – and the equally recurrent process of “creative destruction” – whereby weaker companies die out or, more commonly, get “eaten”.
Take the case of retail and commercial banking, where there remains considerable “biodiversity”. North America and some European markets still have highly fragmented retail banking sectors. The co-operative banking sector has seen the most change, with high levels of consolidation (especially following the crisis of the 1980s surrounding the US savings and loans industry) and most institutions moving to shareholder ownership. But the only species that is now close to extinction in developed countries is the state-owned bank, as privatisation has swept the world.
In other respects, the story is one of speciation – the proliferation of new types of financial institution – which is just what we would expect in a truly evolutionary system. Many new “monoline” financial services companies have emerged in commercial banking, especially in consumer finance (for example, Capital One). A number of new “boutiques” now exist to cater to the private banking market. Direct banking (by telephone and internet) is another relatively recent and growing phenomenon throughout the developed world.
Likewise, even as giants have formed in the realm of investment banking, new and nimbler species have evolved and proliferated. Although what many recognise as the first hedge fund was established as long ago as 1949, their emergence as big players in global financial markets is a relatively recent phenomenon. In 1992 there were just 400 hedge funds, with $50bn (£24bn, €34bn) of assets under management. By the end of 2006 the number had increased more than 20-fold and assets under management by a factor of nearly 30. And by the second quarter of 2007 there were 9,767 such funds, with $1,740bn under management.
Thanks to leverage, the estimated gross investments of the five largest funds amount to around $100bn. Altogether, hedge funds now account for between one-third and a half of all trading in the US and UK equity and bond markets.
Meanwhile, there has been a somewhat smaller surge in the number of private equity partnerships and the assets they manage, while the rapidly accruing hard currency reserves of exporters of manufactured goods and energy are producing a second generation of sovereign wealth funds.
Not only are new forms of financial institution proliferating; so too are new forms of financial asset and service. In recent years, investors’ appetite has grown dramatically for mortgage-backed and other asset-backed securities. The use of derivatives has also increased significantly.
In evolutionary terms, then, the financial services sector appears to be in the midst of a kind of “Cambrian explosion”, with existing species flourishing and new species (such as hedge funds and private equity partnerships) increasing in number. Yes, there are giants such as Citigroup. But, as in the natural world, their existence does not preclude the evolution and continued existence of smaller species. Size is not everything, in finance as in nature.
Indeed, the very difficulties that arise as publicly owned companies become larger and more complex – the diseconomies of scale associated with bureaucracy, the pressures associated with quarterly reporting – make it very probable that new kinds of private firm will proliferate. What matters in evolution is not your size or your complexity. All that matters is that you are good at surviving and reproducing your genes. The financial equivalent is being good at generating returns on equity and generating imitators employing a similar business model. Both are easier for small firms.
★ ★ ★
Mutation and speciation have usually been evolved responses to the environment and competition, with natural selection determining which new traits become widely disseminated. However, the evolutionary process has been subject to recurrent exogenous disruptions in the form of geopolitical shocks, financial crises and regulatory interventions (or lapses). The Great Depression of the 1930s and the Great Inflation of the 1970s stand out as times of major discontinuity, with “mass extinctions” such as the bank panics during the 1930s and the Savings and Loans crisis in the 1980s.
Could something similar happen in our time? Certainly, the sharp change in credit conditions in the summer of 2007 created acute problems for some hedge fund strategies, leaving the funds vulnerable to redemptions by investors. But a more important feature of the recent credit crunch has been the pressure on banks.
More than $60bn of write-downs have so far been acknowledged by the world’s leading banks, but it is widely assumed that as much as $300bn of subprime-related losses will eventually come to light. Pressure is mounting on some banks to bring the assets of other novel organisms – conduits and strategic investment vehicles – back on to their balance sheets. Yet the difficulty of pricing these assets in highly illiquid markets and the need to maintain capital adequacy are making this easier to say than to do. In Europe, for example, average bank capital is now equivalent to less than 10 per cent of assets, compared with around 25 per cent towards the beginning of the 20th century. Some banks must sooner or later choose between increasing their capital and restricting their lending.
And what of the market for mortgage-backed securities? This year’s events have certainly checked the hopes of those who believed that the separation of risk origination and balance sheet management would distribute risk optimally throughout the financial system. US asset-backed issuance has collapsed since August. So has the issuance of collateralised debt obligations, another relatively novel financial life-form.
Nevertheless, the problems of the banks are simultaneously opportunities for some big hedge funds, particularly those that seized the moment to go public when stock markets were buoyant, and for sovereign wealth funds, which are acquiring stakes in big-brand banks at what seem like bargain prices.
★ ★ ★
There is, however, one big difference between nature and finance. Whereas evolution in biology takes place in the natural environment, where change is essentially random (hence the Oxford biologist Richard Dawkins’s image of the blind watchmaker), evolution in financial services occurs within a regulatory framework where – to borrow a phrase from anti-Darwinian creationists – “intelligent design” plays a part.
Sudden changes to the regulatory environment are rather different from sudden changes in the macro-economic environment, which resemble environmental shifts in the natural world. The difference is that there is an element of endogeneity in regulatory changes, since those responsible are often “poachers turned gamekeepers”, with a good insight into the way that the private sector works. However, the net effect is the same as climate change in biological evolution. New rules and regulations can make previously “good” traits suddenly disadvantageous. The rise and fall of the savings and loans institutions, for example, was due in large measure to changes in the regulatory environment in the US.
The primary focus of most financial regulators is to maintain stability within the sector, thereby protecting the consumers whom banks serve and the “real” economy that the industry supports. Companies in non-financial industries are neither so fundamental to the economy, nor so critical to the livelihood of the consumer. The collapse of a leading financial institution, in which retail customers lose their deposits, is an event that any regulator (and politician) wishes to avoid at all costs – a fact of which the British authorities were painfully reminded by the run this summer on Northern Rock, the mortgage bank.
An old question that has raised its head once again in recent months is how far implicit guarantees to bail out banks create a problem of “moral hazard”, encouraging excessive risk-taking on the assumption that the state will intervene if an institution is considered too big – meaning too politically sensitive or too likely to bring a lot of other companies down with it – to fail. From an evolutionary perspective, however, the problem looks slightly different. It is, in fact, undesirable to have any institutions in the category of “too big to fail”, because without occasional bouts of what Joseph Schumpeter, the Harvard economist, termed “creative destruction”, the evolutionary process will be thwarted. Japan’s experience in the 1990s stands as a warning to legislators and regulators that an entire banking sector can become a kind of economic dead hand if institutions are propped up despite underperformance.
Every shock to the financial system must result in casualties. Left to itself, “natural selection” should work fast to eliminate the weakest institutions in the market, which typically are devoured by the successful. But most crises also usher in new rules, as legislators and regulators rush to stabilise the system and protect the consumer/voter. The critical point is that the possibility of extinction cannot and should not be removed by excessively precautionary regulation.
As Schumpeter wrote more than 70 years ago: “This economic system cannot do without the ultima ratio of the complete destruction of those existences which are irretrievably associated with the hopelessly unadapted.” Creative destruction, in his view, meant nothing less than the disappearance of “those firms which are unfit to live”.
The coming months will determine how far, in terms of its economic impact, the current crisis is a true “ice age” as opposed to just a severe winter. It will also determine which among the world’s financial groups are the dinosaurs and which are the fittest mammals.
The writer is professor of history at Harvard University and an FT contributing editor. The Evolution of Financial Services: Making Sense of the Past, Preparing for the Future, by Niall Ferguson and Oliver Wyman, is published this week by Oliver Wyman
The remark was made to the US Congress in September by Anthony Ryan, assistant Treasury secretary. Only when we know the true magnitude of the current financial crisis will we be able fully to appreciate the significance of his words.
Analogies between finance and evolution are in themselves nothing new. “The survival of the fittest” is a phrase that aggressive traders like to use. “It’s Darwinian out there” is a stock utterance by hedge fund managers after an especially tough week. Back in November 2005, a conference hosted by Goldman Sachs, the investment bank, was entitled “The Evolution of Excellence”.
Yet, as became clear at that gathering, when financial practitioners use such terms they seldom understand just how apposite they are. A long-run historical analysis of the development of financial services, going all the way back to the days of Charles Darwin, strongly suggests that evolutionary forces are as much at work in the realm of money as they are in the natural world.
The big question for our time is: are we on the brink of a “great dying” – one of those mass extinctions of species that have occurred periodically in the history of life on earth, such as the Cretaceous-Tertiary crisis that killed off the dinosaurs? It is a scenario that many biologists have reason to fear, as man-made climate change wreaks havoc with natural habitats around the globe. A great dying is also a scenario that financial analysts should worry about, as another man-made disaster – the subprime mortgage crisis – works its way through the global financial system.
★ ★ ★
The notion that Darwinian processes may be at work in the economy was raised by Thorstein Veblen, the Norwegian-American economist best known for his Theory of the Leisure Class, as long ago as 1898. There has been an academic journal devoted to the subject for the past 16 years, though most economists remain sceptical about the applicability of Darwin’s ideas in the economic sphere. The analogy is in fact surprisingly good in the case of the financial services industry, which has many of the defining characteristics of a true evolutionary system:
●“Genes”, in the sense that certain business practices perform the same role as genes in biology, allowing information to be stored in the “organisational memory” and passed on from individual to individual or from company to company when a new one is created.
●The potential for spontaneous “mutation”, usually referred to in the economic world as innovation and primarily, though by no means always, technological.
●Competition among individuals within a species for resources, with the outcomes in terms of longevity and proliferation determining which business practices persist.
●A mechanism for natural selection through the market allocation of capital and human resources and the possibility of death in cases of underperformance, in other words “differential survival”.
●Scope for “speciation”, sustaining biodiversity through the creation of wholly new “species” of financial institutions.
●Scope for extinction, with species dying out altogether.
Financial history is essentially the result of institutional mutation and natural selection. Random “drift” (innovations/mutations that are not promoted by natural selection, but just happen) and “flow” (innovations/mutations that are caused when, say, American practices are adopted by Chinese banks) play a part. There can also be “co-evolution”, when different financial species work and adapt together (like hedge funds and their prime brokers).
But market selection is the main driver. Financial organisms are in competition with one another for finite resources. At certain times and in certain places, certain species may become dominant. But innovations by competitor species, or the emergence of altogether new species, prevent any permanent hierarchy or monoculture from emerging. Broadly speaking, the law of the “survival of the fittest” applies. Institutions with a “selfish gene” that is good at self-replication (and self-perpetuation) will tend to endure and proliferate.
The analogy is, of course, not perfect. When one organism ingests another in the natural world, it is just eating, whereas in financial services mergers and acquisitions can lead directly to mutation. Among financial organisms, there is no counterpart to the role of sexual reproduction. Most financial mutation is deliberate, conscious innovation rather than random change. Indeed, because a company can adapt within its own lifetime to change going on around it, financial evolution (like cultural evolution) may be best described not as Darwinian but Lamarckian, after the French biologist who contended that an individual organism could acquire new and heritable traits. Still, the resemblances outnumber the differences – and evolution certainly offers a better model for understanding financial change than any other we have.
Rudolf Hilferding, the German socialist, a century ago predicted an inexorable movement towards more concentration of ownership in “financial capitalism”. The conventional view of financial development does indeed see the process from the vantage point of the big survivor. In the successful company’s official “family tree”, numerous small companies are seen to converge over time on a common “trunk”, the present-day conglomerate – the kind of giant “überbank” that Hilferding imagined would ultimately take over the entire financial system. However, this is precisely the wrong way to think about financial evolution. Over the long run, financial innovation begins at a common trunk. Over time, the trunk branches outwards as new kinds of bank and other financial institution evolve. The fact that a particular institution successfully devours smaller rivals along the way is more or less irrelevant. In the evolutionary process, animals eat one another, but that is not the driving force behind evolutionary mutation and the emergence of new species and sub-species.
The point is that economies of scale and scope are not always the driving force in financial history. More often, the real drivers are the process of speciation – when new types of company are created – and the equally recurrent process of “creative destruction” – whereby weaker companies die out or, more commonly, get “eaten”.
Take the case of retail and commercial banking, where there remains considerable “biodiversity”. North America and some European markets still have highly fragmented retail banking sectors. The co-operative banking sector has seen the most change, with high levels of consolidation (especially following the crisis of the 1980s surrounding the US savings and loans industry) and most institutions moving to shareholder ownership. But the only species that is now close to extinction in developed countries is the state-owned bank, as privatisation has swept the world.
In other respects, the story is one of speciation – the proliferation of new types of financial institution – which is just what we would expect in a truly evolutionary system. Many new “monoline” financial services companies have emerged in commercial banking, especially in consumer finance (for example, Capital One). A number of new “boutiques” now exist to cater to the private banking market. Direct banking (by telephone and internet) is another relatively recent and growing phenomenon throughout the developed world.
Likewise, even as giants have formed in the realm of investment banking, new and nimbler species have evolved and proliferated. Although what many recognise as the first hedge fund was established as long ago as 1949, their emergence as big players in global financial markets is a relatively recent phenomenon. In 1992 there were just 400 hedge funds, with $50bn (£24bn, €34bn) of assets under management. By the end of 2006 the number had increased more than 20-fold and assets under management by a factor of nearly 30. And by the second quarter of 2007 there were 9,767 such funds, with $1,740bn under management.
Thanks to leverage, the estimated gross investments of the five largest funds amount to around $100bn. Altogether, hedge funds now account for between one-third and a half of all trading in the US and UK equity and bond markets.
Meanwhile, there has been a somewhat smaller surge in the number of private equity partnerships and the assets they manage, while the rapidly accruing hard currency reserves of exporters of manufactured goods and energy are producing a second generation of sovereign wealth funds.
Not only are new forms of financial institution proliferating; so too are new forms of financial asset and service. In recent years, investors’ appetite has grown dramatically for mortgage-backed and other asset-backed securities. The use of derivatives has also increased significantly.
In evolutionary terms, then, the financial services sector appears to be in the midst of a kind of “Cambrian explosion”, with existing species flourishing and new species (such as hedge funds and private equity partnerships) increasing in number. Yes, there are giants such as Citigroup. But, as in the natural world, their existence does not preclude the evolution and continued existence of smaller species. Size is not everything, in finance as in nature.
Indeed, the very difficulties that arise as publicly owned companies become larger and more complex – the diseconomies of scale associated with bureaucracy, the pressures associated with quarterly reporting – make it very probable that new kinds of private firm will proliferate. What matters in evolution is not your size or your complexity. All that matters is that you are good at surviving and reproducing your genes. The financial equivalent is being good at generating returns on equity and generating imitators employing a similar business model. Both are easier for small firms.
★ ★ ★
Mutation and speciation have usually been evolved responses to the environment and competition, with natural selection determining which new traits become widely disseminated. However, the evolutionary process has been subject to recurrent exogenous disruptions in the form of geopolitical shocks, financial crises and regulatory interventions (or lapses). The Great Depression of the 1930s and the Great Inflation of the 1970s stand out as times of major discontinuity, with “mass extinctions” such as the bank panics during the 1930s and the Savings and Loans crisis in the 1980s.
Could something similar happen in our time? Certainly, the sharp change in credit conditions in the summer of 2007 created acute problems for some hedge fund strategies, leaving the funds vulnerable to redemptions by investors. But a more important feature of the recent credit crunch has been the pressure on banks.
More than $60bn of write-downs have so far been acknowledged by the world’s leading banks, but it is widely assumed that as much as $300bn of subprime-related losses will eventually come to light. Pressure is mounting on some banks to bring the assets of other novel organisms – conduits and strategic investment vehicles – back on to their balance sheets. Yet the difficulty of pricing these assets in highly illiquid markets and the need to maintain capital adequacy are making this easier to say than to do. In Europe, for example, average bank capital is now equivalent to less than 10 per cent of assets, compared with around 25 per cent towards the beginning of the 20th century. Some banks must sooner or later choose between increasing their capital and restricting their lending.
And what of the market for mortgage-backed securities? This year’s events have certainly checked the hopes of those who believed that the separation of risk origination and balance sheet management would distribute risk optimally throughout the financial system. US asset-backed issuance has collapsed since August. So has the issuance of collateralised debt obligations, another relatively novel financial life-form.
Nevertheless, the problems of the banks are simultaneously opportunities for some big hedge funds, particularly those that seized the moment to go public when stock markets were buoyant, and for sovereign wealth funds, which are acquiring stakes in big-brand banks at what seem like bargain prices.
★ ★ ★
There is, however, one big difference between nature and finance. Whereas evolution in biology takes place in the natural environment, where change is essentially random (hence the Oxford biologist Richard Dawkins’s image of the blind watchmaker), evolution in financial services occurs within a regulatory framework where – to borrow a phrase from anti-Darwinian creationists – “intelligent design” plays a part.
Sudden changes to the regulatory environment are rather different from sudden changes in the macro-economic environment, which resemble environmental shifts in the natural world. The difference is that there is an element of endogeneity in regulatory changes, since those responsible are often “poachers turned gamekeepers”, with a good insight into the way that the private sector works. However, the net effect is the same as climate change in biological evolution. New rules and regulations can make previously “good” traits suddenly disadvantageous. The rise and fall of the savings and loans institutions, for example, was due in large measure to changes in the regulatory environment in the US.
The primary focus of most financial regulators is to maintain stability within the sector, thereby protecting the consumers whom banks serve and the “real” economy that the industry supports. Companies in non-financial industries are neither so fundamental to the economy, nor so critical to the livelihood of the consumer. The collapse of a leading financial institution, in which retail customers lose their deposits, is an event that any regulator (and politician) wishes to avoid at all costs – a fact of which the British authorities were painfully reminded by the run this summer on Northern Rock, the mortgage bank.
An old question that has raised its head once again in recent months is how far implicit guarantees to bail out banks create a problem of “moral hazard”, encouraging excessive risk-taking on the assumption that the state will intervene if an institution is considered too big – meaning too politically sensitive or too likely to bring a lot of other companies down with it – to fail. From an evolutionary perspective, however, the problem looks slightly different. It is, in fact, undesirable to have any institutions in the category of “too big to fail”, because without occasional bouts of what Joseph Schumpeter, the Harvard economist, termed “creative destruction”, the evolutionary process will be thwarted. Japan’s experience in the 1990s stands as a warning to legislators and regulators that an entire banking sector can become a kind of economic dead hand if institutions are propped up despite underperformance.
Every shock to the financial system must result in casualties. Left to itself, “natural selection” should work fast to eliminate the weakest institutions in the market, which typically are devoured by the successful. But most crises also usher in new rules, as legislators and regulators rush to stabilise the system and protect the consumer/voter. The critical point is that the possibility of extinction cannot and should not be removed by excessively precautionary regulation.
As Schumpeter wrote more than 70 years ago: “This economic system cannot do without the ultima ratio of the complete destruction of those existences which are irretrievably associated with the hopelessly unadapted.” Creative destruction, in his view, meant nothing less than the disappearance of “those firms which are unfit to live”.
The coming months will determine how far, in terms of its economic impact, the current crisis is a true “ice age” as opposed to just a severe winter. It will also determine which among the world’s financial groups are the dinosaurs and which are the fittest mammals.
The writer is professor of history at Harvard University and an FT contributing editor. The Evolution of Financial Services: Making Sense of the Past, Preparing for the Future, by Niall Ferguson and Oliver Wyman, is published this week by Oliver Wyman
Schultz sees an apocalypse now
PETER BRIMELOW
Commentary: Veteran editor declares 'A financial tsunami is upon us'
By Peter Brimelow, MarketWatch
Last update: 12:01 a.m. EST Dec. 13, 2007
NEW YORK (MarketWatch) -- The Fed flops and Wall Street is worried. But one letter veteran has been here before, not that it makes him any cheerier.
Occasionally, I get reader emails claiming that The International Harry Schultz Letter's Harry Schultz is dead. He himself insists in an email to me that he is still alive. But he must be well over 80 now, although he's always been mysterious about his age. I notice that that he's now listed as "editor emeritus," although the letter is still written in his characteristically quirky first-person voice.
Alive or not, Schultz must feel like he's been resurrected. Systemic financial fears, dollar doubts, gold gains, seeping stagflation - a word Schultz claims he coined - all eerily replicate the 1970s, which he began as a derided crank and ended victorious over the financial establishment. (After which, significantly, he was notably quick to say the storm had passed).
Shultz's latest letter, just in, is absolutely apocalyptical: "A financial tsunami is upon us," he says, caused by lax credit and complications introduced by Wall Street's derivatives craze.
Among other interesting ideas raised by Schultz in his intense, somewhat terrifying introduction: recession, possibly depression; bank failures; exchange controls; housing prices down by 50%; credit card company failures; money market fund dangers; tripling of U.S. jobless numbers; federal bail-outs for Fannie Mae (FNM
) and Freddie
Mac (FRE
) .
His advice, translated out of his shorthand style: "If you have not already done so, take immediate measures to safeguard your assets against the global derivative crisis ... Most urgent is close out time deposits, buy non-U.S. government bonds."
In other words, Schultz is saying the U.S. banking system is threatened. How's that for a Christmas greeting?
Schultz says "the second biggest danger is owning U.S. dollars in any form, (it) has crashed and going much lower ... use dollar rallies to exit dollars or sell short ... This is not a time to seek profits, but to protect what U have ... Portfolio diversification is essential in troubled times."
Schultz's favored currencies: "In order of preference: Swiss Franc, Australian dollar, Euro, Canadian dollar."
Schultz is a trader and his specific market advice is nuanced. He writes: "Direction of global stock markets uncertain. Balance stock holdings between long and shorts to counterbalance draw-down risks, and/or hedge exposure via puts, futures, or bear funds ... Exposure to gold shares and bullion should be a minimum of 35-45% of your total portfolio, with at least 10% in physical gold bullion and coins, and/or very rare coins ... "
On gold, he writes: "The public is still not in the gold market. They will be in 2008 as the derivatives and credit crises bring down more financial institutions (amid recession) and eyes will be opened, via pain. While Rome burns, gold will smash through its old unadjusted-for-inflation $850 high on the way to $1,600, & who knows how far beyond ..."
Schultz is still buying a few stocks. His top pick for December: Terra Nitrogen Co. LP, (TNH
) . But he
recommends buying when and if the stock closes above $130 on two consecutive days.
Amid the apocalyptic advice, Schultz finds time to dispense some other helpful hints. Avoid fluoride. Cell phones may cause cancer. Sauerkraut makes for a healthier prostate. Use faxes for all financial transactions. Give money to Republican presidential candidate Ron Paul on his Dec. 16 Boston Tea Party anniversary fundathon.
In case you're wondering, Schultz is up 21.42% over the past 12 months according to the Hulbert Financial Digest, vs. 7.51% for the dividend-reinvested Dow Jones Wilshire 5000. Over the past five years, Schultz is up a remarkable 34.38% annualized vs. 12.85% annualized for the DJW.
Not so easy to dismiss.
Commentary: Veteran editor declares 'A financial tsunami is upon us'
By Peter Brimelow, MarketWatch
Last update: 12:01 a.m. EST Dec. 13, 2007
NEW YORK (MarketWatch) -- The Fed flops and Wall Street is worried. But one letter veteran has been here before, not that it makes him any cheerier.
Occasionally, I get reader emails claiming that The International Harry Schultz Letter's Harry Schultz is dead. He himself insists in an email to me that he is still alive. But he must be well over 80 now, although he's always been mysterious about his age. I notice that that he's now listed as "editor emeritus," although the letter is still written in his characteristically quirky first-person voice.
Alive or not, Schultz must feel like he's been resurrected. Systemic financial fears, dollar doubts, gold gains, seeping stagflation - a word Schultz claims he coined - all eerily replicate the 1970s, which he began as a derided crank and ended victorious over the financial establishment. (After which, significantly, he was notably quick to say the storm had passed).
Shultz's latest letter, just in, is absolutely apocalyptical: "A financial tsunami is upon us," he says, caused by lax credit and complications introduced by Wall Street's derivatives craze.
Among other interesting ideas raised by Schultz in his intense, somewhat terrifying introduction: recession, possibly depression; bank failures; exchange controls; housing prices down by 50%; credit card company failures; money market fund dangers; tripling of U.S. jobless numbers; federal bail-outs for Fannie Mae (FNM
) and Freddie
Mac (FRE
) .
His advice, translated out of his shorthand style: "If you have not already done so, take immediate measures to safeguard your assets against the global derivative crisis ... Most urgent is close out time deposits, buy non-U.S. government bonds."
In other words, Schultz is saying the U.S. banking system is threatened. How's that for a Christmas greeting?
Schultz says "the second biggest danger is owning U.S. dollars in any form, (it) has crashed and going much lower ... use dollar rallies to exit dollars or sell short ... This is not a time to seek profits, but to protect what U have ... Portfolio diversification is essential in troubled times."
Schultz's favored currencies: "In order of preference: Swiss Franc, Australian dollar, Euro, Canadian dollar."
Schultz is a trader and his specific market advice is nuanced. He writes: "Direction of global stock markets uncertain. Balance stock holdings between long and shorts to counterbalance draw-down risks, and/or hedge exposure via puts, futures, or bear funds ... Exposure to gold shares and bullion should be a minimum of 35-45% of your total portfolio, with at least 10% in physical gold bullion and coins, and/or very rare coins ... "
On gold, he writes: "The public is still not in the gold market. They will be in 2008 as the derivatives and credit crises bring down more financial institutions (amid recession) and eyes will be opened, via pain. While Rome burns, gold will smash through its old unadjusted-for-inflation $850 high on the way to $1,600, & who knows how far beyond ..."
Schultz is still buying a few stocks. His top pick for December: Terra Nitrogen Co. LP, (TNH
) . But he
recommends buying when and if the stock closes above $130 on two consecutive days.
Amid the apocalyptic advice, Schultz finds time to dispense some other helpful hints. Avoid fluoride. Cell phones may cause cancer. Sauerkraut makes for a healthier prostate. Use faxes for all financial transactions. Give money to Republican presidential candidate Ron Paul on his Dec. 16 Boston Tea Party anniversary fundathon.
In case you're wondering, Schultz is up 21.42% over the past 12 months according to the Hulbert Financial Digest, vs. 7.51% for the dividend-reinvested Dow Jones Wilshire 5000. Over the past five years, Schultz is up a remarkable 34.38% annualized vs. 12.85% annualized for the DJW.
Not so easy to dismiss.
13 December 2007
The fright before Christmas
Twas Twas the fright before Christmas; the merchants did grouse, Not a damn thing was selling, not even a house; Restocking was futile with goods still on shelves, And the streets
were now teeming with unemployed elves. The FSA warned of a housing collapse, An environment hitherto known just to Japs. And Shanghai and Shenzhen encountered sharp
falls An ominous sign when east Asia appalls. (Only Tesco was thriving – and that was before ‘Fresh and Easy’ was launched – how Wal-Mart did guffaw.) The bankers were
choking on alphabet soup Of CDOs, SIVs; all sorts of gloop. Bond salesmen were sweating, awake in their beds, With visions of dole queues (and widening spreads).
In Floridian fund pools there was such a clatter As portfolios blew up with foul fecal matter. Their managers, much like their bonds, were distressed, With the agents who’d
rated them under arrest, And the banks that had sold everyone down the river Saw their equity ratios down to a sliver; Man turned against man, and the brokers the same
Lashed out at their rivals (it was all just so lame): Punk, Ziegel slashed Goldman Sachs, Morgan and Merrill, And Bear Stearns and Lehman they did also imperil, The markets
a-brim with black swans and fat tails – What happens when mania with credit prevails. The quant funds were savaged as bell curves deflated And CFOs had to be strongly
sedated. Will central banks save us ? The stock markets rally, But interbank lending now feels like Death Valley. The bulls now see good news in looming recession But try to
get upbeat about repossession. The bank stocks are cheap now but could yet get cheaper As retailers cower at the sight of the Reaper. Diversification in assets should work If
lending conditions continue berserk. Some market neutrality also appeals For when event-driven runs out of new deals, And if the unthinkable does now unfold There’ll be
merit in silver and still more in gold. Amid confidence crisis and capital flight
Happy Christmas to all, and to all a good night.
; the merchants did grouse, Not a damn thing was selling, not even a house; Restocking was futile with goods still on shelves, And the streets
were now teeming with unemployed elves. The FSA warned of a housing collapse, An environment hitherto known just to Japs. And Shanghai and Shenzhen encountered sharp
falls An ominous sign when east Asia appalls. (Only Tesco was thriving – and that was before ‘Fresh and Easy’ was launched – how Wal-Mart did guffaw.) The bankers were
choking on alphabet soup Of CDOs, SIVs; all sorts of gloop. Bond salesmen were sweating, awake in their beds, With visions of dole queues (and widening spreads).
In Floridian fund pools there was such a clatter As portfolios blew up with foul fecal matter. Their managers, much like their bonds, were distressed, With the agents who’d
rated them under arrest, And the banks that had sold everyone down the river Saw their equity ratios down to a sliver; Man turned against man, and the brokers the same
Lashed out at their rivals (it was all just so lame): Punk, Ziegel slashed Goldman Sachs, Morgan and Merrill, And Bear Stearns and Lehman they did also imperil, The markets
a-brim with black swans and fat tails – What happens when mania with credit prevails. The quant funds were savaged as bell curves deflated And CFOs had to be strongly
sedated. Will central banks save us ? The stock markets rally, But interbank lending now feels like Death Valley. The bulls now see good news in looming recession But try to
get upbeat about repossession. The bank stocks are cheap now but could yet get cheaper As retailers cower at the sight of the Reaper. Diversification in assets should work If
lending conditions continue berserk. Some market neutrality also appeals For when event-driven runs out of new deals, And if the unthinkable does now unfold There’ll be
merit in silver and still more in gold. Amid confidence crisis and capital flight
Happy Christmas to all, and to all a good night.
were now teeming with unemployed elves. The FSA warned of a housing collapse, An environment hitherto known just to Japs. And Shanghai and Shenzhen encountered sharp
falls An ominous sign when east Asia appalls. (Only Tesco was thriving – and that was before ‘Fresh and Easy’ was launched – how Wal-Mart did guffaw.) The bankers were
choking on alphabet soup Of CDOs, SIVs; all sorts of gloop. Bond salesmen were sweating, awake in their beds, With visions of dole queues (and widening spreads).
In Floridian fund pools there was such a clatter As portfolios blew up with foul fecal matter. Their managers, much like their bonds, were distressed, With the agents who’d
rated them under arrest, And the banks that had sold everyone down the river Saw their equity ratios down to a sliver; Man turned against man, and the brokers the same
Lashed out at their rivals (it was all just so lame): Punk, Ziegel slashed Goldman Sachs, Morgan and Merrill, And Bear Stearns and Lehman they did also imperil, The markets
a-brim with black swans and fat tails – What happens when mania with credit prevails. The quant funds were savaged as bell curves deflated And CFOs had to be strongly
sedated. Will central banks save us ? The stock markets rally, But interbank lending now feels like Death Valley. The bulls now see good news in looming recession But try to
get upbeat about repossession. The bank stocks are cheap now but could yet get cheaper As retailers cower at the sight of the Reaper. Diversification in assets should work If
lending conditions continue berserk. Some market neutrality also appeals For when event-driven runs out of new deals, And if the unthinkable does now unfold There’ll be
merit in silver and still more in gold. Amid confidence crisis and capital flight
Happy Christmas to all, and to all a good night.
; the merchants did grouse, Not a damn thing was selling, not even a house; Restocking was futile with goods still on shelves, And the streets
were now teeming with unemployed elves. The FSA warned of a housing collapse, An environment hitherto known just to Japs. And Shanghai and Shenzhen encountered sharp
falls An ominous sign when east Asia appalls. (Only Tesco was thriving – and that was before ‘Fresh and Easy’ was launched – how Wal-Mart did guffaw.) The bankers were
choking on alphabet soup Of CDOs, SIVs; all sorts of gloop. Bond salesmen were sweating, awake in their beds, With visions of dole queues (and widening spreads).
In Floridian fund pools there was such a clatter As portfolios blew up with foul fecal matter. Their managers, much like their bonds, were distressed, With the agents who’d
rated them under arrest, And the banks that had sold everyone down the river Saw their equity ratios down to a sliver; Man turned against man, and the brokers the same
Lashed out at their rivals (it was all just so lame): Punk, Ziegel slashed Goldman Sachs, Morgan and Merrill, And Bear Stearns and Lehman they did also imperil, The markets
a-brim with black swans and fat tails – What happens when mania with credit prevails. The quant funds were savaged as bell curves deflated And CFOs had to be strongly
sedated. Will central banks save us ? The stock markets rally, But interbank lending now feels like Death Valley. The bulls now see good news in looming recession But try to
get upbeat about repossession. The bank stocks are cheap now but could yet get cheaper As retailers cower at the sight of the Reaper. Diversification in assets should work If
lending conditions continue berserk. Some market neutrality also appeals For when event-driven runs out of new deals, And if the unthinkable does now unfold There’ll be
merit in silver and still more in gold. Amid confidence crisis and capital flight
Happy Christmas to all, and to all a good night.
12 December 2007
Satyajit Das: Socialism for Wall Street
Satyajit Das / New Delhi December 12, 2007
In good times, financial markets embrace capitalism. In bad times, financial markets re-discover socialism. Currently, the US Federal Reserve is engaged in a dangerous strategy to look after its Wall Street friends.
The origins of the current credit crisis lie in a loose monetary policy and excessive capital flows that were turbo-charged by “financial engineering” techniques used by banks. Borrowing bought more borrowing, fuelling price increases in financial assets — debt, equity, property, infrastructure.
In recent months, major banks have reported losses of around $45 billion on their investments. Up to $1 trillion of assets are also on their way back onto bank balance sheets as complex off-balance sheet structures (collateralised debt obligations, conduits issuing asset-backed commercial paper and structured investment vehicles) are unwound.
The major regulatory response has been cuts in the US Fed funds rate (0.75 per cent per annum) and the discount rate. In recent weeks, the differential between inter-bank rates and the central bank targeted rates has widened to levels not seen since August. This points to further potential cuts in both rates by the end of the year. Lower cuts are inconsistent with above-target inflation levels resulting from high oil prices, higher food prices, increasing cost pressures in emerging economies such as China and the potential inflationary effect of a weaker dollar.
The US central bank’s strategy is clear. The current credit problems require a substantial reduction in the level of borrowings and leverage in the global financial system. Asset prices ramped up by excessive debt need to adjust. The adjustment can take place via a “crash”. This would be de-stabilising and would wreak further havoc on already weakened banks.
Alternatively, the de-leveraging and price adjustment can be achieved by creating inflation through a loose monetary policy. If asset prices remain at current levels, higher inflation allows values to fall in real terms. Higher inflation also reduces the value of borrowings that must be paid back allowing the required reduction in leverage.
Between January 1960 and December 1974, the Dow Jones Industrial Average was substantially unchanged. This is despite significant periodic rallies during the “go-go years”. If inflation averaged 5 per cent per annum, then the value of the market (ignoring dividends) lost around half (50 per cent) of its value in real (inflation-adjusted) terms.
The Fed strategy also assists affected banks. The large writedowns in risky assets and the expected re-intermediation of assets mean that some banks need large infusions of capital. Given recent performance and subdued profit outlook, it would be difficult for them to raise this capital at acceptable prices.
Lower short-term interest rates allow banks to borrow cheaply. The money can be used to purchase government bonds that provide higher returns than the cost of borrowing. This generates profits for the bank without the banks having to hold capital against their assets (banks generally are not required to hold capital against government securities). The profits help re-capitalise the bank.
An added benefit is that the US government can fund its deficit by selling its debt to the banks. This would be handy if foreign demand for US Treasuries decreases in response to the weaker dollar. The Bank of Japan used the same strategy to re-capitalise the loss-making Japanese banks after the collapse of the “bubble economy” in 1989.
Higher inflation expectations are already evident in higher gold prices, the steeper US yield curve (long-term rates are higher than short-term rates) and the weaker dollar. Foreign investors, especially large sovereign investment funds, are switching from financial assets (bonds) to “real” assets (companies with real businesses) reflecting higher inflationary expectations.
The strategy is dangerous. Inflation can lead to a significant transfer of wealth from investors to borrowers. Inflation once embedded in the economy distorts economic activity such as investment and savings. The experience of the late 1970s and early 1980s highlights the difficulties in recapturing the inflation beast once uncaged. Paul Volcker, then Chairman of the Federal Reserve, bravely increased interest rates to stratospheric levels to squeeze inflation out of the financial system.
The strategy may also not work. The cuts in rate do not appear to have had the desired effect in improving market liquidity conditions. Default risk concerns continue to inhibit lending and other routine financial transactions. Lower rates may set off further bubbles, for example, in equities and emerging markets. Asset prices may fall sharply anyway. In fairness to Ben Bernanke, he has limited policy alternatives available.
Central bankers have stated that “errant” banks and investors will not be “bailed out”. Actual actions suggest otherwise. Banks have played their “nuclear” option well. The spectre of “systemic risk”, whether real or not, is one a central banker cannot ignore. The strategy has attracted little scrutiny or comment despite being implemented by unelected officials with public money and without any transparent political debate.
In a 1998 speech during the Asian financial crisis, Lawrence Summers, then Deputy Secretary of the US Treasury, preached the merits of American-style “transparency and disclosure”. A new term, “crony capitalism”, was coined to describe the cozy relationship between Asian governments’ regulators and the private sector. It seems that crony capitalism is not exclusive to emerging markets.
Banks continue to privatise gains and socialise losses. Socialism on Wall Street will prevail, once again.
The author is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives
In good times, financial markets embrace capitalism. In bad times, financial markets re-discover socialism. Currently, the US Federal Reserve is engaged in a dangerous strategy to look after its Wall Street friends.
The origins of the current credit crisis lie in a loose monetary policy and excessive capital flows that were turbo-charged by “financial engineering” techniques used by banks. Borrowing bought more borrowing, fuelling price increases in financial assets — debt, equity, property, infrastructure.
In recent months, major banks have reported losses of around $45 billion on their investments. Up to $1 trillion of assets are also on their way back onto bank balance sheets as complex off-balance sheet structures (collateralised debt obligations, conduits issuing asset-backed commercial paper and structured investment vehicles) are unwound.
The major regulatory response has been cuts in the US Fed funds rate (0.75 per cent per annum) and the discount rate. In recent weeks, the differential between inter-bank rates and the central bank targeted rates has widened to levels not seen since August. This points to further potential cuts in both rates by the end of the year. Lower cuts are inconsistent with above-target inflation levels resulting from high oil prices, higher food prices, increasing cost pressures in emerging economies such as China and the potential inflationary effect of a weaker dollar.
The US central bank’s strategy is clear. The current credit problems require a substantial reduction in the level of borrowings and leverage in the global financial system. Asset prices ramped up by excessive debt need to adjust. The adjustment can take place via a “crash”. This would be de-stabilising and would wreak further havoc on already weakened banks.
Alternatively, the de-leveraging and price adjustment can be achieved by creating inflation through a loose monetary policy. If asset prices remain at current levels, higher inflation allows values to fall in real terms. Higher inflation also reduces the value of borrowings that must be paid back allowing the required reduction in leverage.
Between January 1960 and December 1974, the Dow Jones Industrial Average was substantially unchanged. This is despite significant periodic rallies during the “go-go years”. If inflation averaged 5 per cent per annum, then the value of the market (ignoring dividends) lost around half (50 per cent) of its value in real (inflation-adjusted) terms.
The Fed strategy also assists affected banks. The large writedowns in risky assets and the expected re-intermediation of assets mean that some banks need large infusions of capital. Given recent performance and subdued profit outlook, it would be difficult for them to raise this capital at acceptable prices.
Lower short-term interest rates allow banks to borrow cheaply. The money can be used to purchase government bonds that provide higher returns than the cost of borrowing. This generates profits for the bank without the banks having to hold capital against their assets (banks generally are not required to hold capital against government securities). The profits help re-capitalise the bank.
An added benefit is that the US government can fund its deficit by selling its debt to the banks. This would be handy if foreign demand for US Treasuries decreases in response to the weaker dollar. The Bank of Japan used the same strategy to re-capitalise the loss-making Japanese banks after the collapse of the “bubble economy” in 1989.
Higher inflation expectations are already evident in higher gold prices, the steeper US yield curve (long-term rates are higher than short-term rates) and the weaker dollar. Foreign investors, especially large sovereign investment funds, are switching from financial assets (bonds) to “real” assets (companies with real businesses) reflecting higher inflationary expectations.
The strategy is dangerous. Inflation can lead to a significant transfer of wealth from investors to borrowers. Inflation once embedded in the economy distorts economic activity such as investment and savings. The experience of the late 1970s and early 1980s highlights the difficulties in recapturing the inflation beast once uncaged. Paul Volcker, then Chairman of the Federal Reserve, bravely increased interest rates to stratospheric levels to squeeze inflation out of the financial system.
The strategy may also not work. The cuts in rate do not appear to have had the desired effect in improving market liquidity conditions. Default risk concerns continue to inhibit lending and other routine financial transactions. Lower rates may set off further bubbles, for example, in equities and emerging markets. Asset prices may fall sharply anyway. In fairness to Ben Bernanke, he has limited policy alternatives available.
Central bankers have stated that “errant” banks and investors will not be “bailed out”. Actual actions suggest otherwise. Banks have played their “nuclear” option well. The spectre of “systemic risk”, whether real or not, is one a central banker cannot ignore. The strategy has attracted little scrutiny or comment despite being implemented by unelected officials with public money and without any transparent political debate.
In a 1998 speech during the Asian financial crisis, Lawrence Summers, then Deputy Secretary of the US Treasury, preached the merits of American-style “transparency and disclosure”. A new term, “crony capitalism”, was coined to describe the cozy relationship between Asian governments’ regulators and the private sector. It seems that crony capitalism is not exclusive to emerging markets.
Banks continue to privatise gains and socialise losses. Socialism on Wall Street will prevail, once again.
The author is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives
Satyajit Das: Socialism for Wall Street
Satyajit Das / New Delhi December 12, 2007
In good times, financial markets embrace capitalism. In bad times, financial markets re-discover socialism. Currently, the US Federal Reserve is engaged in a dangerous strategy to look after its Wall Street friends.
The origins of the current credit crisis lie in a loose monetary policy and excessive capital flows that were turbo-charged by “financial engineering” techniques used by banks. Borrowing bought more borrowing, fuelling price increases in financial assets — debt, equity, property, infrastructure.
In recent months, major banks have reported losses of around $45 billion on their investments. Up to $1 trillion of assets are also on their way back onto bank balance sheets as complex off-balance sheet structures (collateralised debt obligations, conduits issuing asset-backed commercial paper and structured investment vehicles) are unwound.
The major regulatory response has been cuts in the US Fed funds rate (0.75 per cent per annum) and the discount rate. In recent weeks, the differential between inter-bank rates and the central bank targeted rates has widened to levels not seen since August. This points to further potential cuts in both rates by the end of the year. Lower cuts are inconsistent with above-target inflation levels resulting from high oil prices, higher food prices, increasing cost pressures in emerging economies such as China and the potential inflationary effect of a weaker dollar.
The US central bank’s strategy is clear. The current credit problems require a substantial reduction in the level of borrowings and leverage in the global financial system. Asset prices ramped up by excessive debt need to adjust. The adjustment can take place via a “crash”. This would be de-stabilising and would wreak further havoc on already weakened banks.
Alternatively, the de-leveraging and price adjustment can be achieved by creating inflation through a loose monetary policy. If asset prices remain at current levels, higher inflation allows values to fall in real terms. Higher inflation also reduces the value of borrowings that must be paid back allowing the required reduction in leverage.
Between January 1960 and December 1974, the Dow Jones Industrial Average was substantially unchanged. This is despite significant periodic rallies during the “go-go years”. If inflation averaged 5 per cent per annum, then the value of the market (ignoring dividends) lost around half (50 per cent) of its value in real (inflation-adjusted) terms.
The Fed strategy also assists affected banks. The large writedowns in risky assets and the expected re-intermediation of assets mean that some banks need large infusions of capital. Given recent performance and subdued profit outlook, it would be difficult for them to raise this capital at acceptable prices.
Lower short-term interest rates allow banks to borrow cheaply. The money can be used to purchase government bonds that provide higher returns than the cost of borrowing. This generates profits for the bank without the banks having to hold capital against their assets (banks generally are not required to hold capital against government securities). The profits help re-capitalise the bank.
An added benefit is that the US government can fund its deficit by selling its debt to the banks. This would be handy if foreign demand for US Treasuries decreases in response to the weaker dollar. The Bank of Japan used the same strategy to re-capitalise the loss-making Japanese banks after the collapse of the “bubble economy” in 1989.
Higher inflation expectations are already evident in higher gold prices, the steeper US yield curve (long-term rates are higher than short-term rates) and the weaker dollar. Foreign investors, especially large sovereign investment funds, are switching from financial assets (bonds) to “real” assets (companies with real businesses) reflecting higher inflationary expectations.
The strategy is dangerous. Inflation can lead to a significant transfer of wealth from investors to borrowers. Inflation once embedded in the economy distorts economic activity such as investment and savings. The experience of the late 1970s and early 1980s highlights the difficulties in recapturing the inflation beast once uncaged. Paul Volcker, then Chairman of the Federal Reserve, bravely increased interest rates to stratospheric levels to squeeze inflation out of the financial system.
The strategy may also not work. The cuts in rate do not appear to have had the desired effect in improving market liquidity conditions. Default risk concerns continue to inhibit lending and other routine financial transactions. Lower rates may set off further bubbles, for example, in equities and emerging markets. Asset prices may fall sharply anyway. In fairness to Ben Bernanke, he has limited policy alternatives available.
Central bankers have stated that “errant” banks and investors will not be “bailed out”. Actual actions suggest otherwise. Banks have played their “nuclear” option well. The spectre of “systemic risk”, whether real or not, is one a central banker cannot ignore. The strategy has attracted little scrutiny or comment despite being implemented by unelected officials with public money and without any transparent political debate.
In a 1998 speech during the Asian financial crisis, Lawrence Summers, then Deputy Secretary of the US Treasury, preached the merits of American-style “transparency and disclosure”. A new term, “crony capitalism”, was coined to describe the cozy relationship between Asian governments’ regulators and the private sector. It seems that crony capitalism is not exclusive to emerging markets.
Banks continue to privatise gains and socialise losses. Socialism on Wall Street will prevail, once again.
The author is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives
In good times, financial markets embrace capitalism. In bad times, financial markets re-discover socialism. Currently, the US Federal Reserve is engaged in a dangerous strategy to look after its Wall Street friends.
The origins of the current credit crisis lie in a loose monetary policy and excessive capital flows that were turbo-charged by “financial engineering” techniques used by banks. Borrowing bought more borrowing, fuelling price increases in financial assets — debt, equity, property, infrastructure.
In recent months, major banks have reported losses of around $45 billion on their investments. Up to $1 trillion of assets are also on their way back onto bank balance sheets as complex off-balance sheet structures (collateralised debt obligations, conduits issuing asset-backed commercial paper and structured investment vehicles) are unwound.
The major regulatory response has been cuts in the US Fed funds rate (0.75 per cent per annum) and the discount rate. In recent weeks, the differential between inter-bank rates and the central bank targeted rates has widened to levels not seen since August. This points to further potential cuts in both rates by the end of the year. Lower cuts are inconsistent with above-target inflation levels resulting from high oil prices, higher food prices, increasing cost pressures in emerging economies such as China and the potential inflationary effect of a weaker dollar.
The US central bank’s strategy is clear. The current credit problems require a substantial reduction in the level of borrowings and leverage in the global financial system. Asset prices ramped up by excessive debt need to adjust. The adjustment can take place via a “crash”. This would be de-stabilising and would wreak further havoc on already weakened banks.
Alternatively, the de-leveraging and price adjustment can be achieved by creating inflation through a loose monetary policy. If asset prices remain at current levels, higher inflation allows values to fall in real terms. Higher inflation also reduces the value of borrowings that must be paid back allowing the required reduction in leverage.
Between January 1960 and December 1974, the Dow Jones Industrial Average was substantially unchanged. This is despite significant periodic rallies during the “go-go years”. If inflation averaged 5 per cent per annum, then the value of the market (ignoring dividends) lost around half (50 per cent) of its value in real (inflation-adjusted) terms.
The Fed strategy also assists affected banks. The large writedowns in risky assets and the expected re-intermediation of assets mean that some banks need large infusions of capital. Given recent performance and subdued profit outlook, it would be difficult for them to raise this capital at acceptable prices.
Lower short-term interest rates allow banks to borrow cheaply. The money can be used to purchase government bonds that provide higher returns than the cost of borrowing. This generates profits for the bank without the banks having to hold capital against their assets (banks generally are not required to hold capital against government securities). The profits help re-capitalise the bank.
An added benefit is that the US government can fund its deficit by selling its debt to the banks. This would be handy if foreign demand for US Treasuries decreases in response to the weaker dollar. The Bank of Japan used the same strategy to re-capitalise the loss-making Japanese banks after the collapse of the “bubble economy” in 1989.
Higher inflation expectations are already evident in higher gold prices, the steeper US yield curve (long-term rates are higher than short-term rates) and the weaker dollar. Foreign investors, especially large sovereign investment funds, are switching from financial assets (bonds) to “real” assets (companies with real businesses) reflecting higher inflationary expectations.
The strategy is dangerous. Inflation can lead to a significant transfer of wealth from investors to borrowers. Inflation once embedded in the economy distorts economic activity such as investment and savings. The experience of the late 1970s and early 1980s highlights the difficulties in recapturing the inflation beast once uncaged. Paul Volcker, then Chairman of the Federal Reserve, bravely increased interest rates to stratospheric levels to squeeze inflation out of the financial system.
The strategy may also not work. The cuts in rate do not appear to have had the desired effect in improving market liquidity conditions. Default risk concerns continue to inhibit lending and other routine financial transactions. Lower rates may set off further bubbles, for example, in equities and emerging markets. Asset prices may fall sharply anyway. In fairness to Ben Bernanke, he has limited policy alternatives available.
Central bankers have stated that “errant” banks and investors will not be “bailed out”. Actual actions suggest otherwise. Banks have played their “nuclear” option well. The spectre of “systemic risk”, whether real or not, is one a central banker cannot ignore. The strategy has attracted little scrutiny or comment despite being implemented by unelected officials with public money and without any transparent political debate.
In a 1998 speech during the Asian financial crisis, Lawrence Summers, then Deputy Secretary of the US Treasury, preached the merits of American-style “transparency and disclosure”. A new term, “crony capitalism”, was coined to describe the cozy relationship between Asian governments’ regulators and the private sector. It seems that crony capitalism is not exclusive to emerging markets.
Banks continue to privatise gains and socialise losses. Socialism on Wall Street will prevail, once again.
The author is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives
10 December 2007
Interest rate 'freeze' - the real story is fraud
MORTGAGE MELTDOWN
Interest rate 'freeze' - the real story is fraud
Bankers pay lip service to families while scurrying to avert suits, prison
New proposals to ease our great mortgage meltdown keep rolling in. First the Treasury Department urged the creation of a new fund that would buy risky mortgage bonds as a tactic to hide what those bonds were really worth. (Not much.) Then the idea was to use Fannie Mae and Freddie Mac to buy the risky loans, even if it was clear that U.S. taxpayers would eventually be stuck with the bill. But that plan went south after Fannie suffered a new accounting scandal, and Freddie's existing loan losses shot up more than expected.
Now, just unveiled Thursday, comes the "freeze," the brainchild of Treasury Secretary Henry Paulson. It sounds good: For five years, mortgage lenders will freeze interest rates on a limited number of "teaser" subprime loans. Other homeowners facing foreclosure will be offered assistance from the Federal Housing Administration.
But unfortunately, the "freeze" is just another fraud - and like the other bailout proposals, it has nothing to do with U.S. house prices, with "working families," keeping people in their homes or any of that nonsense.
The sole goal of the freeze is to prevent owners of mortgage-backed securities, many of them foreigners, from suing U.S. banks and forcing them to buy back worthless mortgage securities at face value - right now almost 10 times their market worth.
The ticking time bomb in the U.S. banking system is not resetting subprime mortgage rates. The real problem is the contractual ability of investors in mortgage bonds to require banks to buy back the loans at face value if there was fraud in the origination process.
And, to be sure, fraud is everywhere. It's in the loan application documents, and it's in the appraisals. There are e-mails and memos floating around showing that many people in banks, investment banks and appraisal companies - all the way up to senior management - knew about it.
I can hear the hum of shredders working overtime, and maybe that is the new "hot" industry to invest in. There are lots of people who would like to muzzle subpoena-happy New York Attorney General Andrew Cuomo to buy time and make this all go away. Cuomo is just inches from getting what he needs to start putting a lot of people in prison. I bet some people are trying right now to make him an offer "he can't refuse."
Despite Thursday's ballyhooed new deal with mortgage lenders, does anyone really think that it can ultimately stop fraud lawsuits by mortgage bond investors, many of them spread out across the globe?
The catastrophic consequences of bond investors forcing originators to buy back loans at face value are beyond the current media discussion. The loans at issue dwarf the capital available at the largest U.S. banks combined, and investor lawsuits would raise stunning liability sufficient to cause even the largest U.S. banks to fail, resulting in massive taxpayer-funded bailouts of Fannie and Freddie, and even FDIC.
The problem isn't just subprime loans. It is the entire mortgage market. As home prices fall, defaults will rise sharply - period. And so will the patience of mortgage bondholders. Different classes of mortgage bonds from various risk pools are owned by different central banks, funds, pensions and investors all over the world. Even your pension or 401(k) might have some of these bonds in it.
Perhaps some U.S. government department can make veiled threats to foreign countries to suggest they will suffer unpleasant consequences if their largest holders (central banks and investment funds) don't go along with the plan, but how could it be possible to strong-arm everyone?
What would be prudent and logical is for the banks that sold this toxic waste to buy it back and for a lot of people to go to prison. If they knew about the fraud, they should have to buy the bonds back. The time to look into this is before the shredders have worked their magic - not five years from now.
Those selling the "freeze" have suggested that mortgage-backed securities investors will benefit because they lose more with rising foreclosures. But with fast-depreciating collateral, the last thing investors in mortgage bonds ought to do is put off foreclosures. Rate freezes are at best a tool for delaying the inevitable foreclosures when even the most optimistic forecasters expect home prices to fall. In October, Goldman Sachs issued a report forecasting an incredible 35 to 40 percent drop in California home prices in the coming few years. To minimize losses, a mortgage bondholder would obviously be better off foreclosing on a home before prices plunge.
The goal of the freeze may be to delay bond investors from suing by putting off the big foreclosure wave for several years. But it may also be to stop bond investors from suing. If the investors agreed to loan modifications with the "real" wage and asset information from refinancing borrowers, mortgage originators and bundlers would have an excuse once the foreclosure occurred. They could say, "Fraud? What fraud?! You knew the borrower's real income and asset information later when he refinanced!"
The key is to refinance borrowers whose current loans involved fraud in the origination process. And I assure you it was a minority of borrowers whose loans didn't involve fraud.
The government is trying to accomplish wide-scale refinancing by tricking bond investors, or by tricking U.S. taxpayers. Guess who will foot the bill now that the FHA is entering the fray?
Ultimately, the people in these secret Paulson meetings were probably less worried about saving the mortgage market than with saving themselves. Some might be looking at prison time.
As chief of Goldman Sachs, Paulson was involved, to degrees as yet unrevealed, in the mortgage securitization process during the halcyon days of mortgage fraud from 2004 to 2006.
Paulson became the U.S. Treasury secretary on July 10, 2006, after the extent of the debacle was coming into focus for those in the know. Goldman Sachs achieved recent accolades in the markets for having bet heavily against the housing market, while Citigroup, Morgan Stanley, Bear Sterns, Merrill Lynch and others got hammered for failing to time the end of the credit bubble.
Goldman Sachs is the only major investment bank in the United States that has emerged as yet unscathed from this debacle. The success of its strategy must have resulted from fairly substantial bets against housing, mortgage banking and related industries, which also means that Goldman Sachs saw this coming at the same time they were bundling and selling these loans.
If a mortgage bond investor sues Goldman Sachs to force the institution to buy back loans, could Paulson be forced to testify as to whether Goldman Sachs knew or had reason to know about fraud in the origination process of the loans it was bundling?
It is truly amazing that right now everyone in the country is deferring to Paulson and the heads of Countrywide, JPMorgan, Bank of America and others as the best group to work out a solution to this problem. No one is talking about the fact that these people created the problem and profited to the tune of hundreds of billions of dollars from it.
I suspect that such a group first sat down and tried to figure out how to protect their financial interests and avoid criminal liability. And then when they agreed on the plan, they decided to sell it as "helping working families stay in their homes." That's why these meetings were secret, and reporters and the public weren't invited.
The next time that Paulson is before the Senate Finance Committee, instead of asking, "How much money do you think we should give your banking buddies?" I'd like to see New York Sen. Chuck Schumer ask him what he knew about this staggering fraud at the time he was chief of Goldman Sachs.
The Goldman report in October suggests that rampant investor demand is to blame for origination fraud - even though these investors were misled by high credit ratings from bond rating agencies being paid billions by the U.S. investment banks, like Goldman, that were selling the bundled mortgages.
This logic is like saying shoppers seeking bargain-priced soup encourage the grocery store owner to steal it. I mean, we're talking about criminal fraud here. We are on the cusp of a mammoth financial crisis, and the Federal Reserve and the U.S. Treasury are trying to limit the liability of their banking friends under the guise of trying to help borrowers. At stake is nothing short of the continued existence of the U.S. banking system.
Interest rate 'freeze' - the real story is fraud
Bankers pay lip service to families while scurrying to avert suits, prison
New proposals to ease our great mortgage meltdown keep rolling in. First the Treasury Department urged the creation of a new fund that would buy risky mortgage bonds as a tactic to hide what those bonds were really worth. (Not much.) Then the idea was to use Fannie Mae and Freddie Mac to buy the risky loans, even if it was clear that U.S. taxpayers would eventually be stuck with the bill. But that plan went south after Fannie suffered a new accounting scandal, and Freddie's existing loan losses shot up more than expected.
Now, just unveiled Thursday, comes the "freeze," the brainchild of Treasury Secretary Henry Paulson. It sounds good: For five years, mortgage lenders will freeze interest rates on a limited number of "teaser" subprime loans. Other homeowners facing foreclosure will be offered assistance from the Federal Housing Administration.
But unfortunately, the "freeze" is just another fraud - and like the other bailout proposals, it has nothing to do with U.S. house prices, with "working families," keeping people in their homes or any of that nonsense.
The sole goal of the freeze is to prevent owners of mortgage-backed securities, many of them foreigners, from suing U.S. banks and forcing them to buy back worthless mortgage securities at face value - right now almost 10 times their market worth.
The ticking time bomb in the U.S. banking system is not resetting subprime mortgage rates. The real problem is the contractual ability of investors in mortgage bonds to require banks to buy back the loans at face value if there was fraud in the origination process.
And, to be sure, fraud is everywhere. It's in the loan application documents, and it's in the appraisals. There are e-mails and memos floating around showing that many people in banks, investment banks and appraisal companies - all the way up to senior management - knew about it.
I can hear the hum of shredders working overtime, and maybe that is the new "hot" industry to invest in. There are lots of people who would like to muzzle subpoena-happy New York Attorney General Andrew Cuomo to buy time and make this all go away. Cuomo is just inches from getting what he needs to start putting a lot of people in prison. I bet some people are trying right now to make him an offer "he can't refuse."
Despite Thursday's ballyhooed new deal with mortgage lenders, does anyone really think that it can ultimately stop fraud lawsuits by mortgage bond investors, many of them spread out across the globe?
The catastrophic consequences of bond investors forcing originators to buy back loans at face value are beyond the current media discussion. The loans at issue dwarf the capital available at the largest U.S. banks combined, and investor lawsuits would raise stunning liability sufficient to cause even the largest U.S. banks to fail, resulting in massive taxpayer-funded bailouts of Fannie and Freddie, and even FDIC.
The problem isn't just subprime loans. It is the entire mortgage market. As home prices fall, defaults will rise sharply - period. And so will the patience of mortgage bondholders. Different classes of mortgage bonds from various risk pools are owned by different central banks, funds, pensions and investors all over the world. Even your pension or 401(k) might have some of these bonds in it.
Perhaps some U.S. government department can make veiled threats to foreign countries to suggest they will suffer unpleasant consequences if their largest holders (central banks and investment funds) don't go along with the plan, but how could it be possible to strong-arm everyone?
What would be prudent and logical is for the banks that sold this toxic waste to buy it back and for a lot of people to go to prison. If they knew about the fraud, they should have to buy the bonds back. The time to look into this is before the shredders have worked their magic - not five years from now.
Those selling the "freeze" have suggested that mortgage-backed securities investors will benefit because they lose more with rising foreclosures. But with fast-depreciating collateral, the last thing investors in mortgage bonds ought to do is put off foreclosures. Rate freezes are at best a tool for delaying the inevitable foreclosures when even the most optimistic forecasters expect home prices to fall. In October, Goldman Sachs issued a report forecasting an incredible 35 to 40 percent drop in California home prices in the coming few years. To minimize losses, a mortgage bondholder would obviously be better off foreclosing on a home before prices plunge.
The goal of the freeze may be to delay bond investors from suing by putting off the big foreclosure wave for several years. But it may also be to stop bond investors from suing. If the investors agreed to loan modifications with the "real" wage and asset information from refinancing borrowers, mortgage originators and bundlers would have an excuse once the foreclosure occurred. They could say, "Fraud? What fraud?! You knew the borrower's real income and asset information later when he refinanced!"
The key is to refinance borrowers whose current loans involved fraud in the origination process. And I assure you it was a minority of borrowers whose loans didn't involve fraud.
The government is trying to accomplish wide-scale refinancing by tricking bond investors, or by tricking U.S. taxpayers. Guess who will foot the bill now that the FHA is entering the fray?
Ultimately, the people in these secret Paulson meetings were probably less worried about saving the mortgage market than with saving themselves. Some might be looking at prison time.
As chief of Goldman Sachs, Paulson was involved, to degrees as yet unrevealed, in the mortgage securitization process during the halcyon days of mortgage fraud from 2004 to 2006.
Paulson became the U.S. Treasury secretary on July 10, 2006, after the extent of the debacle was coming into focus for those in the know. Goldman Sachs achieved recent accolades in the markets for having bet heavily against the housing market, while Citigroup, Morgan Stanley, Bear Sterns, Merrill Lynch and others got hammered for failing to time the end of the credit bubble.
Goldman Sachs is the only major investment bank in the United States that has emerged as yet unscathed from this debacle. The success of its strategy must have resulted from fairly substantial bets against housing, mortgage banking and related industries, which also means that Goldman Sachs saw this coming at the same time they were bundling and selling these loans.
If a mortgage bond investor sues Goldman Sachs to force the institution to buy back loans, could Paulson be forced to testify as to whether Goldman Sachs knew or had reason to know about fraud in the origination process of the loans it was bundling?
It is truly amazing that right now everyone in the country is deferring to Paulson and the heads of Countrywide, JPMorgan, Bank of America and others as the best group to work out a solution to this problem. No one is talking about the fact that these people created the problem and profited to the tune of hundreds of billions of dollars from it.
I suspect that such a group first sat down and tried to figure out how to protect their financial interests and avoid criminal liability. And then when they agreed on the plan, they decided to sell it as "helping working families stay in their homes." That's why these meetings were secret, and reporters and the public weren't invited.
The next time that Paulson is before the Senate Finance Committee, instead of asking, "How much money do you think we should give your banking buddies?" I'd like to see New York Sen. Chuck Schumer ask him what he knew about this staggering fraud at the time he was chief of Goldman Sachs.
The Goldman report in October suggests that rampant investor demand is to blame for origination fraud - even though these investors were misled by high credit ratings from bond rating agencies being paid billions by the U.S. investment banks, like Goldman, that were selling the bundled mortgages.
This logic is like saying shoppers seeking bargain-priced soup encourage the grocery store owner to steal it. I mean, we're talking about criminal fraud here. We are on the cusp of a mammoth financial crisis, and the Federal Reserve and the U.S. Treasury are trying to limit the liability of their banking friends under the guise of trying to help borrowers. At stake is nothing short of the continued existence of the U.S. banking system.
7 December 2007
The plan to topple Pakistan's military
- Note interesting about what it says about the Chinese port in Pakistan.
By Ahmed Quraishi
(Speaking Freely is an Asia Times Online feature that allows guest writers to have their say.)
ISLAMABAD - On the evening of September 26, 2006, Pakistani strongman Pervez Musharraf walked into the studio of Comedy Central's Daily Show with Jon Stewart, the first sitting president anywhere to dare do this political satire show.
Stewart offered his guest some tea and cookies and played the perfect host by asking, "Is it good?" before springing a surprise: "Where's Osama bin Laden?"
"I don't know," Musharraf replied, as the audience enjoyed the rare sight of a strong leader apparently cornered. "You know where he is?" Musharraf snapped back, "You lead on, we'll follow you."
What General Musharraf didn't know then is that he really was being cornered. Some of the smiles that greeted him in Washington and back home gave no hint of the betrayal that awaited him.
As he completed the remaining part of his US visit, his allies in Washington and elsewhere, as all evidence suggests now, were plotting his downfall. They had decided to take a page from the book of successful "color revolutions" where Western governments covertly used money, private media, student unions, NGOs and international pressure to stage coups, basically overthrowing individuals not fitting well with Washington's agenda.
This recipe proved its success in former Yugoslavia, and more recently in Georgia, Ukraine and Kazakhstan.
In Pakistan, the target is a president who refuses to play ball with the US on Afghanistan, China and Dr Abdul Qadeer Khan.
To get rid of him, an impressive operation is underway:
A carefully crafted media blitzkrieg launched early this year assailing the Pakistani president from all sides, questioning his power, his role in Washington's "war on terror" and predicting his downfall.
Money pumped into the country to pay for organized dissent.
Willing activists assigned to mobilize and organize accessible social groups.
A campaign waged on the Internet where tens of mailing lists and "news agencies" have sprung up from nowhere, all demonizing Musharraf and the Pakistani military.
European- and American-funded Pakistani NGOs taking a temporary leave from their real work to serve as a makeshift anti-government mobilization machine.
US government agencies directly funding some private Pakistani television networks; the channels go into an open anti-government mode, cashing in on some manufactured and other real public grievances regarding inflation and corruption.
Some of Musharraf's shady and corrupt political allies feed this campaign, hoping to stay in power under a weakened president.
All this groundwork completed and chips were in place when the judicial crisis broke out in March. Even Pakistani politicians were surprised at a well-greased and well-organized lawyers' campaign, complete with flyers, rented cars and buses, excellent event-management and media outreach.
Currently, students are being recruited and organized into a street movement. The work is ongoing and urban Pakistani students are being cultivated, especially using popular Internet Web sites and "online hangouts". The people behind this effort are mostly unknown and faceless, limiting themselves to organizing sporadic, small student gatherings in Lahore and Islamabad, complete with banners, placards and little babies with arm bands for maximum media effect. No major student association has announced yet that it is behind these student protests, which is a very interesting fact glossed over by most journalists covering the story.
Only a few students from affluent schools have responded so far, and it's not because the Pakistani government's countermeasures are effective. They're not. The reason is that social activism attracts people from affluent backgrounds, closely reflecting a uniquely Pakistani phenomenon where local non-governmental organizations are mostly founded and run by rich, Westernized Pakistanis.
All of this may appear to be spur-of-the-moment and Musharraf-specific. But it all really began almost three years ago, when, out of the blue and recycling old political arguments, Akbar Bugti launched an armed rebellion against the Pakistani state, surprising security analysts by using rockets and other military equipment that shouldn't normally be available to a smalltime village thug. Since then, Islamabad has sat on a pile of evidence that links Bugti's campaign to money and ammunition and logistical support from Afghanistan, directly aided by the Karzai administration and India, with the US turning a blind eye.
For reasons not clear to our analysts yet, Islamabad has kept quiet on Washington's involvement with anti-Pakistan elements in Afghanistan. But Pakistan did send an indirect public message to America recently.
"We have indications of Indian involvement with anti-state elements in Pakistan," declared the spokesman of the Pakistan Foreign Office in a regular briefing in October. The statement was terse and direct, and the spokesman, Tasnim Aslam, quickly moved on to other issues.
This is how a Pakistani official explained Aslam's statement: "What she was really saying is this: We know what the Indians are doing. They've sold the Americans on the idea that [the Indians] are an authority on Pakistan and can be helpful in Afghanistan. The Americans have bought the idea and are in on the plan, giving the Indians a free hand in Afghanistan. What the Americans don't know is that we, too, know the Indians very well. Better still, we know Afghanistan very well. You can't beat us at our own game."
Bugti's armed rebellion coincided with the Gwadar project entering its final stages. No coincidence here. Bugti's real job was to scare the Chinese away and scuttle Chinese President Hu Jintao's planned visit to Gwadar a few months later to formally launch the port city.
Gwadar is the pinnacle of Sino-Pakistani strategic cooperation. It's a modern city that is supposed to link Pakistan, Central Asia, western China with markets in Mideast and Africa. It's supposed to have roads stretching all the way to China. It's no coincidence that that country has also earmarked millions of dollars to renovate the Karakoram Highway linking northern Pakistan to western China.
Some reports in the US media, however, have accused Pakistan and China of building a naval base in the guise of a commercial seaport directly overlooking international oil-shipping lanes. The Indians and some other regional actors are also not comfortable with this project because they see it as commercial competition.
What Bugti's regional and international supporters never expected is Pakistan moving firmly and strongly to nip his rebellion in the bud. Even Bugti himself probably never expected the Pakistani state to react in the way it did to his betrayal of the homeland. He was killed in a military operation where scores of his mercenaries surrendered to Pakistan army soldiers.
United States intelligence and their Indian advisors could not cultivate an immediate replacement for Bugti. So they moved to Plan B. They supported Abdullah Mehsud, a Pakistani Taliban fighter held for five years in Guantanamo Bay, and then handed him over back to the Afghan government, only to return to his homeland, Pakistan, to kidnap two Chinese engineers working in Balochistan, one of whom was eventually killed during a rescue operation by the Pakistani government.
Islamabad could not tolerate this shadowy figure, who was creating a following among ordinary Pakistanis masquerading as a Taliban while in reality towing a vague agenda. He was eliminated earlier this year by Pakistani security forces while secretly returning from Afghanistan after meeting his handlers there. Again, no surprises here.
Smelling a rat
This is where Pakistani political and military officials finally started smelling a rat. All of this was an indication of a bigger problem. There were growing indications that, ever since Islamabad joined Washington's regional plans, Pakistan was gradually turning into a "besieged-nation", heavily targeted by the US media while being subjected to strategic sabotage and espionage from Afghanistan.
Afghanistan, under America's watch, has turned into a vast staging ground for sophisticated psychological and military operations to destabilize neighboring Pakistan.
During the past three years, the heat has gradually been turned up against Pakistan and its military along Pakistan's western regions:
A shadowy group called the BLA, a Cold War relic, rose from the dead to restart a separatist war in southwestern Pakistan.
Bugti's death was a blow to neo-BLA, but the shadowy group's backers didn't repent. His grandson, Brahmdagh Bugti, is currently enjoying a safe shelter in the Afghan capital, Kabul, where he continues to operate and remote-control his assets in Pakistan.
Saboteurs trained in Afghanistan have been inserted into Pakistan to aggravate extremist passions here, especially after the Red Mosque operation.
Chinese citizens continue to be targeted by individuals pretending to be Islamists, when no known Islamic group has claimed responsibility.
A succession of "religious rebels" with suspicious foreign links have suddenly emerged in Pakistan over the past months claiming to be "Pakistani Taliban". Some of the names include Abdul Rashid Ghazi, Baitullah Mehsud, and now the Maulana of Swat. Some of them have used, and are using, encrypted communication equipment far superior to what the Pakistani military owns.
Money and weapons have been fed into the religious movements and al-Qaeda remnants in the tribal areas.
Exploiting the situation, assets within the Pakistani media started promoting the idea that the Pakistani military was killing its own people. The rest of the unsuspecting media quickly picked up this message. Some botched US and Pakistani military operations against al-Qaeda that caused civilian deaths accidentally fed this media campaign.
This was the perfect timing for the launch of Military, Inc: Inside Pakistan's Military Economy, a book authored by Ayesha Siddiqa Agha, a columnist for a Pakistani English-language paper and a correspondent for "Jane's Defence Weekly", a private intelligence service founded by experts close to British intelligence.
Target: Pakistan military
The book was launched in Pakistan in early 2007 by Oxford Press. And, contrary to most reports, it is openly available in Islamabad's biggest bookshops. The book portrays the Pakistani military as an institution that is eating up whatever little resources Pakistan has.
The Pakistani military's successful financial management, creating alternate financial sources to spend on a vast military machine and build a conventional and nuclear near-match with a neighboring adversary five times larger - an impressive record for any nation by any standard - was distorted in the book and reduced to a mere attempt by the military to control the nation's economy in the same way it was controlling its politics.
The timing was interesting. After all, it was hard to defend a military in the eyes of its own proud people when the chief of the military is ruling the country, the army is fighting insurgents and extremists who claim to be defending Islam, grumpy politicians are out of business, and the military's side businesses, meant to feed the nation's military machine, are doing well compared to the shabby state of the nation's civilian departments.
A closer look at Siddiqa, the author, revealed disturbing information to Pakistani officials. In the months before launching her book, she was a frequent visitor to India where, as a defense expert, she cultivated important contacts. On her return, she developed friendship with an female Indian diplomat posted in Islamabad. Both of these activities - travel to India and ties to Indian diplomats - are not a crime in Pakistan and don't raise interest anymore. Pakistanis are hospitable and friendly people and these qualities have been amply displayed to the Indians during the four-year-old peace process.
What is interesting is that Siddiqa left her car in the house of the said Indian diplomat during one of her recent trips to London. And, according to a report, she stayed in London at a place owned by an individual linked to the Indian diplomat in Islamabad.
The point is this: Who assigned her to investigate the Pakistani Armed Forces and present a distorted image of a proud and efficient Pakistani institution?
From 1988 to 2001, Siddiqa worked in the Pakistan civil service and the Pakistani civil bureaucracy. Her responsibilities included dealing with Military Accounts, which come under the Pakistan Ministry of Defense. She had 13 years of experience in dealing with the budgetary matters of the Pakistani military and people working in this area.
Siddiqa received a year-long fellowship to research and write a book in the US. There are strong indications that some of her Indian contacts played a role in arranging financing for her book project through a paid fellowship. The final manuscript of her book was vetted at a publishing office in New Delhi.
All of these details are insignificant if detached from the real issue at hand. And the issue is the demonization of the Pakistani military as an integral part of the media siege around Pakistan, with the US media leading the way in this campaign.
Some of the juicy details of this campaign include:
The attempt by Siddiqa to pit junior officers against senior officers in Pakistan Armed Forces by alleging discrimination in the distribution of benefits. Apart from being malicious and unfounded, her argument was carefully designed to generate frustration and demoralize Pakistani soldiers.
The US media insisting on handing over Khan to the US so that a final conviction against the Pakistani military can be secured.
Benazir Bhutto demanding after returning to Pakistan that the ISI be restructured; and in a press conference during her house arrest in Lahore in November she went as far as asking Pakistan army officers to revolt against the army chief, a damning attempt at destroying a professional army from within.
Some of this appears to be eerily similar to the campaign waged against the Pakistani military in 1999, when, in July that year, an unsigned full-page advertisement appeared in major American newspapers with the following headline: "A Modern Rogue Army With Its Finger On The Nuclear Button."
Until this day, it is not clear who exactly paid for such an expensive advertisement. But one thing is clear: the agenda behind that advertisement is back in action.
Strangely, just a few days before Bhutto's statements about restructuring the ISI and her open call to army officers to stage a mutiny against their leadership, the conservative US magazine The Weekly Standard interviewed an American security expert who offered similar ideas:
"A large number of ISI agents who are responsible for helping the Taliban and al-Qaeda should be thrown in jail or killed. What I think we should do in Pakistan is a parallel version of what Iran has run against us in Iraq: giving money [and] empowering actors. Some of this will involve working with some shady characters, but the alternative - sending US forces into Pakistan for a sustained bombing campaign - is worse," Steve Schippert was quoted as saying a November 2007 issue of Weekly Standard.
In addition to these media attacks, which security experts call "psychological operations", the US media and politicians have intensified over the past year their campaign to prepare the international public opinion to accept a western intervention in Pakistan along the lines of Iraq and Afghanistan:
Newsweek came up with an entire cover story with a single storyline: Pakistan is a more dangerous place than Iraq.
Senior American politicians, Republican and Democrat, have argued that Pakistan is more dangerous than Iran and merits similar treatment. On October 20 , Senator Joe Biden told ABC News that Washington needs to put soldiers on the ground in Pakistan and invite the international community to join in. "We should be in there," he said. "We should be supplying tens of millions of dollars to build new schools to compete with the madrassas. We should be in there building democratic institutions. We should be in there, and get the rest of the world in there, giving some structure to the emergence of, hopefully, the reemergence of a democratic process."
The International Crisis Group (ICG) has recommended gradual sanctions on Pakistan similar to those imposed on Iran, e.g. slapping travel bans on Pakistani military officers and seizing Pakistani military assets abroad.
The process of painting Pakistan's nuclear assets as pure evil lying around waiting for some do-gooder to come in and "secure" has reached unprecedented levels, with the US media again depicting Pakistan as a nation incapable of protecting its nuclear installations. On October 22, Jane Harman from the US House Intelligence Panel gave the following statement: "I think the US would be wise - and I trust we are doing this - to have contingency plans [to seize Pakistan's nuclear assets], especially because should [Musharraf] fall, there are nuclear weapons there."
The US media has now begun discussing the possibility of Pakistan breaking up and the possibility of new states of "Balochistan" and "Pashtunistan" being carved out of it. Interestingly, one of the first acts of the shady Maulana of Swat, after capturing a few towns, was to take down the Pakistani flag from the top of state buildings and replace them with his own party flag.
The "chatter" about Musharraf's eminent fall has also increased dramatically in the mainly US media, which has been very generous in marketing theories about how Musharraf might "disappear" or be "removed" from the scene. According to some Pakistani analysts, this could be an attempt to prepare the public opinion for a possible assassination of the Pakistani president.
Another worrying thing is how US officials are publicly signaling to the Pakistanis that Bhutto has their backing as the next leader of the country. Such signals from Washington are not only a kiss of death for any public leader in Pakistan, but the Americans also know that their actions are inviting potential assassins to target Bhutto.
If she is killed in this way, there won't be enough time to find the real culprit, but what's certain is that unprecedented international pressure will be placed on Islamabad while everyone will use their local assets to create maximum internal chaos in the country. A dress rehearsal of this scenario has already taken place in October when no less than the UN Security Council itself intervened to ask the international community to "assist" in the investigations into the assassination attempt on Bhutto on October 18. This generous move was sponsored by the US and, interestingly, had no input from Pakistan which did not ask for help in investigations in the first place.
Some Pakistani security analysts privately say that US "chatter" about Musharraf or Bhutto getting killed is a serious matter that can't be easily dismissed. Getting Bhutto killed can generate the kind of pressure that could result in permanently putting the Pakistani military on a back foot, giving Washington enough room to push for installing a new pliant leadership in Islamabad.
Getting Musharraf killed isn't a bad option either. The unknown Islamists can always be blamed, the military will not be able to put another soldier at the top, and circumstances will be created to ensure that either Bhutto or someone like her is eased into power.
The US is very serious this time. They cannot let Pakistan get out of their hands. They were kicked out of Uzbekistan last year, where they were maintaining bases. They are in trouble in Afghanistan and Iraq. Iran continues to be a mess for them and Russia and China are not making it any easier. Pakistan must be "secured" at all costs.
This is why most Pakistanis have never seen US diplomats in Pakistan active like this before. And it's not just the current US ambassador, who has added one more address to her other most-frequently-visited address in Karachi, Bhutto's house. The new address is the office of GEO, one of two news channels shut down by Islamabad for not signing the mandatory code-of-conduct. Thirty-eight other channels are operating and no one has censored the newspapers. But never mind this. The Americans have developed a "thing" for GEO. No solace of course for ARY, the other banned channel.
There's also Bryan Hunt, the US consul-general in Lahore, who wears the national Pakistani dress, the long shirt and baggy trousers, and is moving around these days issuing tough warnings to the Pakistani government and Musharraf to end emergency rule, resign as army chief and give Bhutto access to power.
Pakistan's options
So what should Islamabad do in the face of such a structured campaign to bring Pakistan down to its knees and forcibly install a pro-Washington administration?
There is increasing talk in Islamabad these days about Pakistan's new tough stand in the face of this malicious campaign.
As a starter, Islamabad blew the wind out of the visit of US Deputy Secretary of State John Negroponte who came to Pakistan recently "to deliver a tough message" to the Pakistani president. Musharraf, to his credit, told him he won't end emergency rule until all objectives are achieved.
These objectives include:
Cleaning up northern and western parts of the country of all foreign operatives and their domestic pawns.
Ensuring that Washington's plan for regime-change doesn't succeed.
Purging the Pakistani media of all those elements that were willing or unwilling accomplices in the plan to destabilize the country.
Musharraf has also told Washington publicly that "Pakistan is more important than democracy or the constitution". This is a bold position. This kind of boldness would have served Musharraf better had it come a little earlier. But even now, his media management team is unable to make the most out of it.
Washington will not stand by watching as its plan for regime change in Islamabad goes down the drain. In case the US insists on interfering in Pakistani affairs, Islamabad, according to sources, is looking at some tough measures:
Cutting off oil supplies to US military in Afghanistan. Pakistani officials are already enraged at how Afghanistan has turned into a staging ground for sabotage in Pakistan. If Islamabad continues to see Washington acting as a bully, Pakistani officials are seriously considering an announcement where Pakistan, for the first time since October 2001, will deny the US use of Pakistani soil and air space to transport fuel to Afghanistan.
Reviewing Pakistan's role in the "war on terror". Islamabad needs to fight terrorists on its border with Afghanistan. But our methods need to be different to Washington's when it comes to our domestic extremists. This is where Islamabad parts ways with Washington. Pakistani officials are considering the option of withdrawing from the war on terror while maintaining Pakistan's own war against the terrorists along Afghanistan's border.
Talks with the Taliban. Pakistan has no quarrel with Afghanistan's Taliban. They are Kabul's internal problem. But if reaching out to Afghan Taliban's Mullah Omar can have a positive impact on rebellious Pakistani extremists, then this step should be taken. The South Koreans can talk to the Taliban. Karzai has also called for talks with them. It is time that Islamabad does the same.
The US has been telling everyone in the world that they have paid Pakistan $10 billion over the past five years. They might think this gives them the right to decide Pakistan's destiny. What they don't tell the world is how Pakistan's help secured for them their biggest footprint ever in energy-rich Central Asia.
If they forget, Islamabad can always remind them by giving them the same treatment that Uzbekistan did last year.
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Ahmed Quraishi is an investigative reporter, currently hosting a weekly political talk show titled Worldview From Islamabad, which he created for state-run PTV News, Pakistan's largest television network. See http://www.ahmedquraishi.com
By Ahmed Quraishi
(Speaking Freely is an Asia Times Online feature that allows guest writers to have their say.)
ISLAMABAD - On the evening of September 26, 2006, Pakistani strongman Pervez Musharraf walked into the studio of Comedy Central's Daily Show with Jon Stewart, the first sitting president anywhere to dare do this political satire show.
Stewart offered his guest some tea and cookies and played the perfect host by asking, "Is it good?" before springing a surprise: "Where's Osama bin Laden?"
"I don't know," Musharraf replied, as the audience enjoyed the rare sight of a strong leader apparently cornered. "You know where he is?" Musharraf snapped back, "You lead on, we'll follow you."
What General Musharraf didn't know then is that he really was being cornered. Some of the smiles that greeted him in Washington and back home gave no hint of the betrayal that awaited him.
As he completed the remaining part of his US visit, his allies in Washington and elsewhere, as all evidence suggests now, were plotting his downfall. They had decided to take a page from the book of successful "color revolutions" where Western governments covertly used money, private media, student unions, NGOs and international pressure to stage coups, basically overthrowing individuals not fitting well with Washington's agenda.
This recipe proved its success in former Yugoslavia, and more recently in Georgia, Ukraine and Kazakhstan.
In Pakistan, the target is a president who refuses to play ball with the US on Afghanistan, China and Dr Abdul Qadeer Khan.
To get rid of him, an impressive operation is underway:
A carefully crafted media blitzkrieg launched early this year assailing the Pakistani president from all sides, questioning his power, his role in Washington's "war on terror" and predicting his downfall.
Money pumped into the country to pay for organized dissent.
Willing activists assigned to mobilize and organize accessible social groups.
A campaign waged on the Internet where tens of mailing lists and "news agencies" have sprung up from nowhere, all demonizing Musharraf and the Pakistani military.
European- and American-funded Pakistani NGOs taking a temporary leave from their real work to serve as a makeshift anti-government mobilization machine.
US government agencies directly funding some private Pakistani television networks; the channels go into an open anti-government mode, cashing in on some manufactured and other real public grievances regarding inflation and corruption.
Some of Musharraf's shady and corrupt political allies feed this campaign, hoping to stay in power under a weakened president.
All this groundwork completed and chips were in place when the judicial crisis broke out in March. Even Pakistani politicians were surprised at a well-greased and well-organized lawyers' campaign, complete with flyers, rented cars and buses, excellent event-management and media outreach.
Currently, students are being recruited and organized into a street movement. The work is ongoing and urban Pakistani students are being cultivated, especially using popular Internet Web sites and "online hangouts". The people behind this effort are mostly unknown and faceless, limiting themselves to organizing sporadic, small student gatherings in Lahore and Islamabad, complete with banners, placards and little babies with arm bands for maximum media effect. No major student association has announced yet that it is behind these student protests, which is a very interesting fact glossed over by most journalists covering the story.
Only a few students from affluent schools have responded so far, and it's not because the Pakistani government's countermeasures are effective. They're not. The reason is that social activism attracts people from affluent backgrounds, closely reflecting a uniquely Pakistani phenomenon where local non-governmental organizations are mostly founded and run by rich, Westernized Pakistanis.
All of this may appear to be spur-of-the-moment and Musharraf-specific. But it all really began almost three years ago, when, out of the blue and recycling old political arguments, Akbar Bugti launched an armed rebellion against the Pakistani state, surprising security analysts by using rockets and other military equipment that shouldn't normally be available to a smalltime village thug. Since then, Islamabad has sat on a pile of evidence that links Bugti's campaign to money and ammunition and logistical support from Afghanistan, directly aided by the Karzai administration and India, with the US turning a blind eye.
For reasons not clear to our analysts yet, Islamabad has kept quiet on Washington's involvement with anti-Pakistan elements in Afghanistan. But Pakistan did send an indirect public message to America recently.
"We have indications of Indian involvement with anti-state elements in Pakistan," declared the spokesman of the Pakistan Foreign Office in a regular briefing in October. The statement was terse and direct, and the spokesman, Tasnim Aslam, quickly moved on to other issues.
This is how a Pakistani official explained Aslam's statement: "What she was really saying is this: We know what the Indians are doing. They've sold the Americans on the idea that [the Indians] are an authority on Pakistan and can be helpful in Afghanistan. The Americans have bought the idea and are in on the plan, giving the Indians a free hand in Afghanistan. What the Americans don't know is that we, too, know the Indians very well. Better still, we know Afghanistan very well. You can't beat us at our own game."
Bugti's armed rebellion coincided with the Gwadar project entering its final stages. No coincidence here. Bugti's real job was to scare the Chinese away and scuttle Chinese President Hu Jintao's planned visit to Gwadar a few months later to formally launch the port city.
Gwadar is the pinnacle of Sino-Pakistani strategic cooperation. It's a modern city that is supposed to link Pakistan, Central Asia, western China with markets in Mideast and Africa. It's supposed to have roads stretching all the way to China. It's no coincidence that that country has also earmarked millions of dollars to renovate the Karakoram Highway linking northern Pakistan to western China.
Some reports in the US media, however, have accused Pakistan and China of building a naval base in the guise of a commercial seaport directly overlooking international oil-shipping lanes. The Indians and some other regional actors are also not comfortable with this project because they see it as commercial competition.
What Bugti's regional and international supporters never expected is Pakistan moving firmly and strongly to nip his rebellion in the bud. Even Bugti himself probably never expected the Pakistani state to react in the way it did to his betrayal of the homeland. He was killed in a military operation where scores of his mercenaries surrendered to Pakistan army soldiers.
United States intelligence and their Indian advisors could not cultivate an immediate replacement for Bugti. So they moved to Plan B. They supported Abdullah Mehsud, a Pakistani Taliban fighter held for five years in Guantanamo Bay, and then handed him over back to the Afghan government, only to return to his homeland, Pakistan, to kidnap two Chinese engineers working in Balochistan, one of whom was eventually killed during a rescue operation by the Pakistani government.
Islamabad could not tolerate this shadowy figure, who was creating a following among ordinary Pakistanis masquerading as a Taliban while in reality towing a vague agenda. He was eliminated earlier this year by Pakistani security forces while secretly returning from Afghanistan after meeting his handlers there. Again, no surprises here.
Smelling a rat
This is where Pakistani political and military officials finally started smelling a rat. All of this was an indication of a bigger problem. There were growing indications that, ever since Islamabad joined Washington's regional plans, Pakistan was gradually turning into a "besieged-nation", heavily targeted by the US media while being subjected to strategic sabotage and espionage from Afghanistan.
Afghanistan, under America's watch, has turned into a vast staging ground for sophisticated psychological and military operations to destabilize neighboring Pakistan.
During the past three years, the heat has gradually been turned up against Pakistan and its military along Pakistan's western regions:
A shadowy group called the BLA, a Cold War relic, rose from the dead to restart a separatist war in southwestern Pakistan.
Bugti's death was a blow to neo-BLA, but the shadowy group's backers didn't repent. His grandson, Brahmdagh Bugti, is currently enjoying a safe shelter in the Afghan capital, Kabul, where he continues to operate and remote-control his assets in Pakistan.
Saboteurs trained in Afghanistan have been inserted into Pakistan to aggravate extremist passions here, especially after the Red Mosque operation.
Chinese citizens continue to be targeted by individuals pretending to be Islamists, when no known Islamic group has claimed responsibility.
A succession of "religious rebels" with suspicious foreign links have suddenly emerged in Pakistan over the past months claiming to be "Pakistani Taliban". Some of the names include Abdul Rashid Ghazi, Baitullah Mehsud, and now the Maulana of Swat. Some of them have used, and are using, encrypted communication equipment far superior to what the Pakistani military owns.
Money and weapons have been fed into the religious movements and al-Qaeda remnants in the tribal areas.
Exploiting the situation, assets within the Pakistani media started promoting the idea that the Pakistani military was killing its own people. The rest of the unsuspecting media quickly picked up this message. Some botched US and Pakistani military operations against al-Qaeda that caused civilian deaths accidentally fed this media campaign.
This was the perfect timing for the launch of Military, Inc: Inside Pakistan's Military Economy, a book authored by Ayesha Siddiqa Agha, a columnist for a Pakistani English-language paper and a correspondent for "Jane's Defence Weekly", a private intelligence service founded by experts close to British intelligence.
Target: Pakistan military
The book was launched in Pakistan in early 2007 by Oxford Press. And, contrary to most reports, it is openly available in Islamabad's biggest bookshops. The book portrays the Pakistani military as an institution that is eating up whatever little resources Pakistan has.
The Pakistani military's successful financial management, creating alternate financial sources to spend on a vast military machine and build a conventional and nuclear near-match with a neighboring adversary five times larger - an impressive record for any nation by any standard - was distorted in the book and reduced to a mere attempt by the military to control the nation's economy in the same way it was controlling its politics.
The timing was interesting. After all, it was hard to defend a military in the eyes of its own proud people when the chief of the military is ruling the country, the army is fighting insurgents and extremists who claim to be defending Islam, grumpy politicians are out of business, and the military's side businesses, meant to feed the nation's military machine, are doing well compared to the shabby state of the nation's civilian departments.
A closer look at Siddiqa, the author, revealed disturbing information to Pakistani officials. In the months before launching her book, she was a frequent visitor to India where, as a defense expert, she cultivated important contacts. On her return, she developed friendship with an female Indian diplomat posted in Islamabad. Both of these activities - travel to India and ties to Indian diplomats - are not a crime in Pakistan and don't raise interest anymore. Pakistanis are hospitable and friendly people and these qualities have been amply displayed to the Indians during the four-year-old peace process.
What is interesting is that Siddiqa left her car in the house of the said Indian diplomat during one of her recent trips to London. And, according to a report, she stayed in London at a place owned by an individual linked to the Indian diplomat in Islamabad.
The point is this: Who assigned her to investigate the Pakistani Armed Forces and present a distorted image of a proud and efficient Pakistani institution?
From 1988 to 2001, Siddiqa worked in the Pakistan civil service and the Pakistani civil bureaucracy. Her responsibilities included dealing with Military Accounts, which come under the Pakistan Ministry of Defense. She had 13 years of experience in dealing with the budgetary matters of the Pakistani military and people working in this area.
Siddiqa received a year-long fellowship to research and write a book in the US. There are strong indications that some of her Indian contacts played a role in arranging financing for her book project through a paid fellowship. The final manuscript of her book was vetted at a publishing office in New Delhi.
All of these details are insignificant if detached from the real issue at hand. And the issue is the demonization of the Pakistani military as an integral part of the media siege around Pakistan, with the US media leading the way in this campaign.
Some of the juicy details of this campaign include:
The attempt by Siddiqa to pit junior officers against senior officers in Pakistan Armed Forces by alleging discrimination in the distribution of benefits. Apart from being malicious and unfounded, her argument was carefully designed to generate frustration and demoralize Pakistani soldiers.
The US media insisting on handing over Khan to the US so that a final conviction against the Pakistani military can be secured.
Benazir Bhutto demanding after returning to Pakistan that the ISI be restructured; and in a press conference during her house arrest in Lahore in November she went as far as asking Pakistan army officers to revolt against the army chief, a damning attempt at destroying a professional army from within.
Some of this appears to be eerily similar to the campaign waged against the Pakistani military in 1999, when, in July that year, an unsigned full-page advertisement appeared in major American newspapers with the following headline: "A Modern Rogue Army With Its Finger On The Nuclear Button."
Until this day, it is not clear who exactly paid for such an expensive advertisement. But one thing is clear: the agenda behind that advertisement is back in action.
Strangely, just a few days before Bhutto's statements about restructuring the ISI and her open call to army officers to stage a mutiny against their leadership, the conservative US magazine The Weekly Standard interviewed an American security expert who offered similar ideas:
"A large number of ISI agents who are responsible for helping the Taliban and al-Qaeda should be thrown in jail or killed. What I think we should do in Pakistan is a parallel version of what Iran has run against us in Iraq: giving money [and] empowering actors. Some of this will involve working with some shady characters, but the alternative - sending US forces into Pakistan for a sustained bombing campaign - is worse," Steve Schippert was quoted as saying a November 2007 issue of Weekly Standard.
In addition to these media attacks, which security experts call "psychological operations", the US media and politicians have intensified over the past year their campaign to prepare the international public opinion to accept a western intervention in Pakistan along the lines of Iraq and Afghanistan:
Newsweek came up with an entire cover story with a single storyline: Pakistan is a more dangerous place than Iraq.
Senior American politicians, Republican and Democrat, have argued that Pakistan is more dangerous than Iran and merits similar treatment. On October 20 , Senator Joe Biden told ABC News that Washington needs to put soldiers on the ground in Pakistan and invite the international community to join in. "We should be in there," he said. "We should be supplying tens of millions of dollars to build new schools to compete with the madrassas. We should be in there building democratic institutions. We should be in there, and get the rest of the world in there, giving some structure to the emergence of, hopefully, the reemergence of a democratic process."
The International Crisis Group (ICG) has recommended gradual sanctions on Pakistan similar to those imposed on Iran, e.g. slapping travel bans on Pakistani military officers and seizing Pakistani military assets abroad.
The process of painting Pakistan's nuclear assets as pure evil lying around waiting for some do-gooder to come in and "secure" has reached unprecedented levels, with the US media again depicting Pakistan as a nation incapable of protecting its nuclear installations. On October 22, Jane Harman from the US House Intelligence Panel gave the following statement: "I think the US would be wise - and I trust we are doing this - to have contingency plans [to seize Pakistan's nuclear assets], especially because should [Musharraf] fall, there are nuclear weapons there."
The US media has now begun discussing the possibility of Pakistan breaking up and the possibility of new states of "Balochistan" and "Pashtunistan" being carved out of it. Interestingly, one of the first acts of the shady Maulana of Swat, after capturing a few towns, was to take down the Pakistani flag from the top of state buildings and replace them with his own party flag.
The "chatter" about Musharraf's eminent fall has also increased dramatically in the mainly US media, which has been very generous in marketing theories about how Musharraf might "disappear" or be "removed" from the scene. According to some Pakistani analysts, this could be an attempt to prepare the public opinion for a possible assassination of the Pakistani president.
Another worrying thing is how US officials are publicly signaling to the Pakistanis that Bhutto has their backing as the next leader of the country. Such signals from Washington are not only a kiss of death for any public leader in Pakistan, but the Americans also know that their actions are inviting potential assassins to target Bhutto.
If she is killed in this way, there won't be enough time to find the real culprit, but what's certain is that unprecedented international pressure will be placed on Islamabad while everyone will use their local assets to create maximum internal chaos in the country. A dress rehearsal of this scenario has already taken place in October when no less than the UN Security Council itself intervened to ask the international community to "assist" in the investigations into the assassination attempt on Bhutto on October 18. This generous move was sponsored by the US and, interestingly, had no input from Pakistan which did not ask for help in investigations in the first place.
Some Pakistani security analysts privately say that US "chatter" about Musharraf or Bhutto getting killed is a serious matter that can't be easily dismissed. Getting Bhutto killed can generate the kind of pressure that could result in permanently putting the Pakistani military on a back foot, giving Washington enough room to push for installing a new pliant leadership in Islamabad.
Getting Musharraf killed isn't a bad option either. The unknown Islamists can always be blamed, the military will not be able to put another soldier at the top, and circumstances will be created to ensure that either Bhutto or someone like her is eased into power.
The US is very serious this time. They cannot let Pakistan get out of their hands. They were kicked out of Uzbekistan last year, where they were maintaining bases. They are in trouble in Afghanistan and Iraq. Iran continues to be a mess for them and Russia and China are not making it any easier. Pakistan must be "secured" at all costs.
This is why most Pakistanis have never seen US diplomats in Pakistan active like this before. And it's not just the current US ambassador, who has added one more address to her other most-frequently-visited address in Karachi, Bhutto's house. The new address is the office of GEO, one of two news channels shut down by Islamabad for not signing the mandatory code-of-conduct. Thirty-eight other channels are operating and no one has censored the newspapers. But never mind this. The Americans have developed a "thing" for GEO. No solace of course for ARY, the other banned channel.
There's also Bryan Hunt, the US consul-general in Lahore, who wears the national Pakistani dress, the long shirt and baggy trousers, and is moving around these days issuing tough warnings to the Pakistani government and Musharraf to end emergency rule, resign as army chief and give Bhutto access to power.
Pakistan's options
So what should Islamabad do in the face of such a structured campaign to bring Pakistan down to its knees and forcibly install a pro-Washington administration?
There is increasing talk in Islamabad these days about Pakistan's new tough stand in the face of this malicious campaign.
As a starter, Islamabad blew the wind out of the visit of US Deputy Secretary of State John Negroponte who came to Pakistan recently "to deliver a tough message" to the Pakistani president. Musharraf, to his credit, told him he won't end emergency rule until all objectives are achieved.
These objectives include:
Cleaning up northern and western parts of the country of all foreign operatives and their domestic pawns.
Ensuring that Washington's plan for regime-change doesn't succeed.
Purging the Pakistani media of all those elements that were willing or unwilling accomplices in the plan to destabilize the country.
Musharraf has also told Washington publicly that "Pakistan is more important than democracy or the constitution". This is a bold position. This kind of boldness would have served Musharraf better had it come a little earlier. But even now, his media management team is unable to make the most out of it.
Washington will not stand by watching as its plan for regime change in Islamabad goes down the drain. In case the US insists on interfering in Pakistani affairs, Islamabad, according to sources, is looking at some tough measures:
Cutting off oil supplies to US military in Afghanistan. Pakistani officials are already enraged at how Afghanistan has turned into a staging ground for sabotage in Pakistan. If Islamabad continues to see Washington acting as a bully, Pakistani officials are seriously considering an announcement where Pakistan, for the first time since October 2001, will deny the US use of Pakistani soil and air space to transport fuel to Afghanistan.
Reviewing Pakistan's role in the "war on terror". Islamabad needs to fight terrorists on its border with Afghanistan. But our methods need to be different to Washington's when it comes to our domestic extremists. This is where Islamabad parts ways with Washington. Pakistani officials are considering the option of withdrawing from the war on terror while maintaining Pakistan's own war against the terrorists along Afghanistan's border.
Talks with the Taliban. Pakistan has no quarrel with Afghanistan's Taliban. They are Kabul's internal problem. But if reaching out to Afghan Taliban's Mullah Omar can have a positive impact on rebellious Pakistani extremists, then this step should be taken. The South Koreans can talk to the Taliban. Karzai has also called for talks with them. It is time that Islamabad does the same.
The US has been telling everyone in the world that they have paid Pakistan $10 billion over the past five years. They might think this gives them the right to decide Pakistan's destiny. What they don't tell the world is how Pakistan's help secured for them their biggest footprint ever in energy-rich Central Asia.
If they forget, Islamabad can always remind them by giving them the same treatment that Uzbekistan did last year.
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Ahmed Quraishi is an investigative reporter, currently hosting a weekly political talk show titled Worldview From Islamabad, which he created for state-run PTV News, Pakistan's largest television network. See http://www.ahmedquraishi.com
6 December 2007
It's Not 1929, but It's the Biggest Mess Since
By Steven Pearlstein
Wednesday, December 5, 2007; D01
It was Charles Mackay, the 19th-century Scottish journalist, who observed that men go mad in herds but only come to their senses one by one.
We are only at the beginning of the financial world coming to its senses after the bursting of the biggest credit bubble the world has seen. Everyone seems to acknowledge now that there will be lots of mortgage foreclosures and that house prices will fall nationally for the first time since the Great Depression. Some lenders and hedge funds have failed, while some banks have taken painful write-offs and fired executives. There's even a growing recognition that a recession is over the horizon.
But let me assure you, you ain't seen nothing, yet.
What's important to understand is that, contrary to what you heard from President Bush yesterday, this isn't just a mortgage or housing crisis. The financial giants that originated, packaged, rated and insured all those subprime mortgages were the same ones, run by the same executives, with the same fee incentives, using the same financial technologies and risk-management systems, who originated, packaged, rated and insured home-equity loans, commercial real estate loans, credit card loans and loans to finance corporate buyouts.
It is highly unlikely that these organizations did a significantly better job with those other lines of business than they did with mortgages. But the extent of those misjudgments will be revealed only once the economy has slowed, as it surely will.
At the center of this still-unfolding disaster is the Collateralized Debt Obligation, or CDO. CDOs are not new -- they were at the center of a boom and bust in manufacturing housing loans in the early 2000s. But in the past several years, the CDO market has exploded, fueling not only a mortgage boom but expansion of all manner of credit. By one estimate, the face value of outstanding CDOs is nearly $2 trillion.
But let's begin with the mortgage-backed CDO.
By now, almost everyone knows that most mortgages are no longer held by banks until they are paid off: They are packaged with other mortgages and sold to investors much like a bond.
In the simple version, each investor owned a small percentage of the entire package and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in tranches corresponding to different levels of credit risk. Under this arrangement, if any of the mortgages in the pool defaulted, the riskiest tranche would absorb all the losses until its entire investment was wiped out, followed by the next riskiest and the next.
With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches -- those with the lowest credit ratings -- were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the "mezzanine" tranches, which offered middling yields for supposedly moderate risks.
Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities -- some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.
It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees. And because so much borrowed money was used -- in buying the original mortgages, buying the tranches for the CDOs and then in buying the tranches of the CDOs -- the whole thing was so highly leveraged that the returns, at least on paper, were very attractive. No wonder they were snatched up by British hedge funds, German savings banks, oil-rich Norwegian villages and Florida pension funds.
What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value.
One analysis, by Eidesis Capital, a fund specializing in CDOs, estimates that, of the CDOs issued during the peak years of 2006 and 2007, investors in all but the AAA tranches will lose all their money, and even those will suffer losses of 6 to 31 percent.
And looking across the sector, J.P. Morgan's CDO analysts estimate that there will be at least $300 billion in eventual credit losses, the bulk of which is still hidden from public view. That includes at least $30 billion in additional write-downs at major banks and investment houses, and much more at hedge funds that, for the most part, remain in a state of denial.
As part of the unwinding process, the rating agencies are in the midst of a massive and embarrassing downgrading process that will force many banks, pension funds and money market funds to sell their CDO holdings into a market so bereft of buyers that, in one recent transaction, a desperate E-Trade was able to get only 27 cents on the dollar for its highly rated portfolio.
Meanwhile, banks that are forced to hold on to their CDO assets will be required to set aside much more of their own capital as a financial cushion. That will sharply reduce the money they have available for making new loans.
And it doesn't stop there. CDO losses now threaten the AAA ratings of a number of insurance companies that bought CDO paper or insured against CDO losses. And because some of those insurers also have provided insurance to investors in tax-exempt bonds, states and municipalities have decided to pull back on new bond offerings because investors have become skittish.
If all this sounds like a financial house of cards, that's because it is. And it is about to come crashing down, with serious consequences not only for banks and investors but for the economy as a whole.
That's not just my opinion. It's why banks are husbanding their cash and why the outstanding stock of bank loans and commercial paper is shrinking dramatically.
It is why Treasury officials are working overtime on schemes to stem the tide of mortgage foreclosures and provide a new vehicle to buy up CDO assets.
It's why state and federal budget officials are anticipating sharp decreases in tax revenue next year.
And it is why the Federal Reserve is now willing to toss aside concerns about inflation, the dollar and bailing out Wall Street, and move aggressively to cut interest rates and pump additional funds directly into the banking system.
This may not be 1929. But it's a good bet that it's way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001.
Wednesday, December 5, 2007; D01
It was Charles Mackay, the 19th-century Scottish journalist, who observed that men go mad in herds but only come to their senses one by one.
We are only at the beginning of the financial world coming to its senses after the bursting of the biggest credit bubble the world has seen. Everyone seems to acknowledge now that there will be lots of mortgage foreclosures and that house prices will fall nationally for the first time since the Great Depression. Some lenders and hedge funds have failed, while some banks have taken painful write-offs and fired executives. There's even a growing recognition that a recession is over the horizon.
But let me assure you, you ain't seen nothing, yet.
What's important to understand is that, contrary to what you heard from President Bush yesterday, this isn't just a mortgage or housing crisis. The financial giants that originated, packaged, rated and insured all those subprime mortgages were the same ones, run by the same executives, with the same fee incentives, using the same financial technologies and risk-management systems, who originated, packaged, rated and insured home-equity loans, commercial real estate loans, credit card loans and loans to finance corporate buyouts.
It is highly unlikely that these organizations did a significantly better job with those other lines of business than they did with mortgages. But the extent of those misjudgments will be revealed only once the economy has slowed, as it surely will.
At the center of this still-unfolding disaster is the Collateralized Debt Obligation, or CDO. CDOs are not new -- they were at the center of a boom and bust in manufacturing housing loans in the early 2000s. But in the past several years, the CDO market has exploded, fueling not only a mortgage boom but expansion of all manner of credit. By one estimate, the face value of outstanding CDOs is nearly $2 trillion.
But let's begin with the mortgage-backed CDO.
By now, almost everyone knows that most mortgages are no longer held by banks until they are paid off: They are packaged with other mortgages and sold to investors much like a bond.
In the simple version, each investor owned a small percentage of the entire package and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in tranches corresponding to different levels of credit risk. Under this arrangement, if any of the mortgages in the pool defaulted, the riskiest tranche would absorb all the losses until its entire investment was wiped out, followed by the next riskiest and the next.
With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches -- those with the lowest credit ratings -- were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the "mezzanine" tranches, which offered middling yields for supposedly moderate risks.
Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities -- some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.
It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees. And because so much borrowed money was used -- in buying the original mortgages, buying the tranches for the CDOs and then in buying the tranches of the CDOs -- the whole thing was so highly leveraged that the returns, at least on paper, were very attractive. No wonder they were snatched up by British hedge funds, German savings banks, oil-rich Norwegian villages and Florida pension funds.
What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value.
One analysis, by Eidesis Capital, a fund specializing in CDOs, estimates that, of the CDOs issued during the peak years of 2006 and 2007, investors in all but the AAA tranches will lose all their money, and even those will suffer losses of 6 to 31 percent.
And looking across the sector, J.P. Morgan's CDO analysts estimate that there will be at least $300 billion in eventual credit losses, the bulk of which is still hidden from public view. That includes at least $30 billion in additional write-downs at major banks and investment houses, and much more at hedge funds that, for the most part, remain in a state of denial.
As part of the unwinding process, the rating agencies are in the midst of a massive and embarrassing downgrading process that will force many banks, pension funds and money market funds to sell their CDO holdings into a market so bereft of buyers that, in one recent transaction, a desperate E-Trade was able to get only 27 cents on the dollar for its highly rated portfolio.
Meanwhile, banks that are forced to hold on to their CDO assets will be required to set aside much more of their own capital as a financial cushion. That will sharply reduce the money they have available for making new loans.
And it doesn't stop there. CDO losses now threaten the AAA ratings of a number of insurance companies that bought CDO paper or insured against CDO losses. And because some of those insurers also have provided insurance to investors in tax-exempt bonds, states and municipalities have decided to pull back on new bond offerings because investors have become skittish.
If all this sounds like a financial house of cards, that's because it is. And it is about to come crashing down, with serious consequences not only for banks and investors but for the economy as a whole.
That's not just my opinion. It's why banks are husbanding their cash and why the outstanding stock of bank loans and commercial paper is shrinking dramatically.
It is why Treasury officials are working overtime on schemes to stem the tide of mortgage foreclosures and provide a new vehicle to buy up CDO assets.
It's why state and federal budget officials are anticipating sharp decreases in tax revenue next year.
And it is why the Federal Reserve is now willing to toss aside concerns about inflation, the dollar and bailing out Wall Street, and move aggressively to cut interest rates and pump additional funds directly into the banking system.
This may not be 1929. But it's a good bet that it's way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001.
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