Taleb soars over pompous journos, the clueless predictions of economists and a politician called David. Not to be missed.
The idea that All swans are white" was held to be true, in all possible worlds until black swans were found in Western Australia. That discovery changed, forever, the way we view the world and our understanding of what is possible. Nassim Taleb has taken the discovery of black swans in the natural world and utilised it as a metaphor for unprecedented happenings. The internet, the 9/11 attack on New York and the recent global financial crisis are examples of Black Swan events. Such events were once unimaginable yet like a black swan, they are now part of our known world.
Highlights of Nassim Taleb in conversation with UK Conservative party leader David Cameron. They discuss how Black Swan thinking can be applied to make an economy more robust and less prone to collapse.
Download
http://mpegmedia.abc.net.au/rn/podcast/2009/11/cpt_20091102.mp3
Showing posts with label black swan. Show all posts
Showing posts with label black swan. Show all posts
2 November 2009
4 May 2009
The End of Ponzi Prosperity ~ Satyajit Das
04.05.2009
Lessons of the Global Financial Crisis: 1. The End of Ponzi Prosperity
By: Satyajit Das
We Are All Keynesians Now!
In January 1971, Richard Nixon recanted years of opposition to budget deficits declaring: "Now, I am a Keynesian." Nixon had borrowed the line from Milton Friedman who had used it in 1965. Then, we embraced Monetarism and flirted with "supply side" economics, christened "voodoo economics" by President George Bush Senior. Now, in the wake of the Global Financial Crisis ("GFC"), it seems that we are all Keynesians again.
The GFC is really a "Minsky moment". In Stabilizing an Unstable Economy (1986), Hyman Minsky outlined a hypotheses that excessive risk taking, driven in part by stability lead to market breakdowns - stability is itself destablising.
The current crisis is financial, economic, social and increasingly ideological. Nikolas Sarkozy, President of France, has pronounced the death of laissez-faire capitalism: "c’est fini". World leaders have penned fevered attacks on neo-liberalism. Even religious leaders have spoken out.
Dead economists have been resurrected in support of political positions. As Keynes himself observed: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."
No "pure" economic model has been implemented in living memory, except perhaps in North Korea. The theories themselves rarely work. John Kenneth Galbraith is reported as saying: "Milton’s [Friedman’s] misfortune is that his policies have been tried."
Criticisms of the ancien regime are substantive and deserved. There have been undoubtedly egregious market failures, management excesses and errors in the lead up to the GFC. But the key lessons of the crisis may be subtler than first evident.
Growth has been driven by cheap and abundant debt and uncosted carbon emissions and other forms of pollution. The reality is that this period of growth may be coming to an end.
All brands of politics and economics have been informed by assumptions about the sustainability of high levels of economic growth and the belief that governments and central bankers can exert a substantial degree of control over the economy. Harry Johnson, the famed Chicago economist, writing about England in the 1970s with his wife Elizabeth in (1978) The Shadow of Keynes provides a vivid description of this pre-occupation: "…faster economic growth is the pancea for all..economic and for all that matter political problems and that faster growth can be easily achieved by a combination of inflationary demand-managementpolocies and poltically appealing fiscal gimmickry."
Goldilocks Economy
P.J.O’Rourke writing in Eat The Rich (1998) observed that: "Economics is an entire scientific discipline of not knowing what you’re talking about."
Recent global prosperity derived from a fortunate confluence of low inflation and low interest rates. In the 1980s, brutally high interest rates and recessions squeezed inflation out of the economy facilitating lower interest rates. Low energy prices, following the first Gulf War, helped keep inflation low and fuelled growth.
The fall of the Berlin Wall in 1989 and the reintegration of the command economies of Eastern Europe, China and India into global trade provided low cost labour helping maintain the supply of cheap goods and services. Emerging economies provided substantial new markets for products and capital driven by the very high levels of savings in these countries.
Deregulation of key industries, such as banking and telecommunications, fostered growth by increasing access to finance and improved essential infrastructure. Adoption of new technologies, such as information technology and the Internet, improved productivity and assisted growth, though the extent is disputed.
Many countries switched from employer or government pension schemes to private retirement saving arrangements underwritten by generous tax incentives. Rapid growth in this pool of investment capital was also a factor in growth.
Governments, irrespective of political persuasion, benefited from the favourable economic environment. The ability of governments and central banks to control and "fine tune" the economy with a judicial mixture of monetary and fiscal policy became an article of accepted faith. Voters were lulled into false confidence by a mixture of rising wealth, improved living standards and stability.
Elegant theories about the "Great Moderation" or "Goldilocks Economy", with the benefit of hindsight, seem to be little more than narrative fallacies where a convincing but meaningless story is shaped to fit unconnected facts and coincidence is confused with causality.
Ponzi Prosperity
Growth, in reality, was founded on a series of elegant Ponzi schemes.
Consumption rather than investment drove growth, particularly in the developed world. Debt fuelled consumption became the norm. In the new economy, there were three kinds of people – "the haves", "the have-nots", and "the have-not-paid-for-what-they-haves".
The consumption was financed by borrowings supplied by a deregulated financial system. Many workers’ earnings fell in inflation adjusted terms as a result of global competition and associated outsourcing and off shoring practices. The ability to borrow against the appreciation in owner occupied houses and other financial assets underpinned consumption.
Investors, central banks with large reserves, pension funds and asset managers channeling privatised retirement savings, eagerly purchased the debt. Borrowing fueled higher asset prices allowing even greater levels of borrowing against the value of the asset. This virtuous cycle – a "positive feedback loop" – fueled the "doctor feel good" economy of recent years.
"Financial engineering" replaced "real engineering" in many countries. Entire cities (London and New York) and economies (Iceland) become dominated by the rapidly growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10% in the early 1980s to 40% in 2007. The stockmarket value of financial services firms increased from 6% in the early 1980s to 23% in 2007.
The reliance on financial innovation proved disastrous. In A Short History of Financial Euphoria (1994), John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."
Financially engineered growth extended into international trade flows. Since the 1990s, there has been a substantial build-up of foreign reserves in central banks of emerging markets and developing countries that became the foundation for a trade finance scheme.
Many global currencies were pegged to the dollar at an artificially low rate, like the Chinese Renminbi, to maintain export competitiveness. This created an outflow of dollars (via the trade deficit driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers purchased US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flowed back to the US to finance the spending on imports.
The process relied on the historically unimpeachable credit quality of the USA and large, liquid markets in dollars and dollar investments capable of accommodating the very large investment requirements. This merry-go-round kept US interest rates and cost of capital low encouraging further borrowing to finance consumption and imports to keep the cycle going.
Foreign central banks holding reserves were lending the funds used to purchase goods from the country. The exporting nations never got paid at least until the loan to the buyer (the vendor finance) was paid off. Essentially, growth in global trade was also debt fuelled.
Moderate debt levels are sustainable provided the value of the asset supporting the borrowing is stable and significantly higher than the amount of the loan. The borrower or the collateral for the loan must generate sufficient income to service and repay the borrowing. In the frenzied market environment of low interest rates and ever rising asset prices, the level of collateral cover and ability to service the loans deteriorated sharply. In 2005, rising interest rates and a cooling in the US housing market set the stage for the GFC.
Sigmund Freud once remarked that: "Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces." The GFC was the reality on which the fake pleasure of the Great Moderation and Goldilocks economy was smashed.
Taking the Cure
There is currently confusion between the disease and the cure. The "disease" is the excessive debt and leverage in the financial system, especially in the US, Great Britain, Spain and Australia. The "cure" is the reduction of the level of debt that is now underway (the great "de-leveraging").
The initial phase of the cure is the reduction in debt within the financial system. Some of the debt created during the Ponzi prosperity years will not be repaid. Non-repayment of this debt, in turn, has caused the failure of financial institutions. The process destroys both existing debt and also limits the capacity for further credit creation by financial institutions.
Total losses from the GFC to financial institutions, according the latest estimates, will be in excess of US$ 2 trillion. Banks need additional capital to cover assets that were parked in the "shadow banking system" (the complex of off-balance sheet special purpose vehicles) but are now returning to the mother ship’s balance sheet. The global banking system, in aggregate, is close to technically insolvent.
Commercial sources for recapitalisation are limited as losses mount and the outlook for the financial services industry has deteriorated. Government ownership or de facto nationalisation is the only option to maintain a viable banking system in many countries.
Even after recapitalisation the capital shortfall in the global banking system is likely to be around US$ 1-3 trillion. This equates to a forced contraction in global credit of around 20-30% from existing levels.
The second phase of the cure is the effect on the real economy. The problems of the financial sector have increased the cost and reduced availability of debt to borrowers for legitimate business purposes. The scarcity of capital means that banks must reduce their balance sheets by reducing their stock of loans. Normal financing and loans are now being effectively rationed in global markets.
This forces corporations to reduce leverage by cutting costs, selling assets, reducing investment and raising equity. This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.
"Negative feedback loops" mean reduction in investment and consumption lowers economic activity, placing stresses on corporations and individuals setting off bankruptcies that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt.
Within the financial sector, de-leveraging is well advanced. In the real economy it is in the early stages. The process echoes Joseph Schumpter’s famous maxim of "creative destruction".
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
This article draws on the ideas first published in Satyajit Das "Built to Fail" in The Monthly (April 2009) 8-13
http://www.eurointelligence.com/article.581+M553774d2c37.0.html
Lessons of the Global Financial Crisis: 1. The End of Ponzi Prosperity
By: Satyajit Das
We Are All Keynesians Now!
In January 1971, Richard Nixon recanted years of opposition to budget deficits declaring: "Now, I am a Keynesian." Nixon had borrowed the line from Milton Friedman who had used it in 1965. Then, we embraced Monetarism and flirted with "supply side" economics, christened "voodoo economics" by President George Bush Senior. Now, in the wake of the Global Financial Crisis ("GFC"), it seems that we are all Keynesians again.
The GFC is really a "Minsky moment". In Stabilizing an Unstable Economy (1986), Hyman Minsky outlined a hypotheses that excessive risk taking, driven in part by stability lead to market breakdowns - stability is itself destablising.
The current crisis is financial, economic, social and increasingly ideological. Nikolas Sarkozy, President of France, has pronounced the death of laissez-faire capitalism: "c’est fini". World leaders have penned fevered attacks on neo-liberalism. Even religious leaders have spoken out.
Dead economists have been resurrected in support of political positions. As Keynes himself observed: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."
No "pure" economic model has been implemented in living memory, except perhaps in North Korea. The theories themselves rarely work. John Kenneth Galbraith is reported as saying: "Milton’s [Friedman’s] misfortune is that his policies have been tried."
Criticisms of the ancien regime are substantive and deserved. There have been undoubtedly egregious market failures, management excesses and errors in the lead up to the GFC. But the key lessons of the crisis may be subtler than first evident.
Growth has been driven by cheap and abundant debt and uncosted carbon emissions and other forms of pollution. The reality is that this period of growth may be coming to an end.
All brands of politics and economics have been informed by assumptions about the sustainability of high levels of economic growth and the belief that governments and central bankers can exert a substantial degree of control over the economy. Harry Johnson, the famed Chicago economist, writing about England in the 1970s with his wife Elizabeth in (1978) The Shadow of Keynes provides a vivid description of this pre-occupation: "…faster economic growth is the pancea for all..economic and for all that matter political problems and that faster growth can be easily achieved by a combination of inflationary demand-managementpolocies and poltically appealing fiscal gimmickry."
Goldilocks Economy
P.J.O’Rourke writing in Eat The Rich (1998) observed that: "Economics is an entire scientific discipline of not knowing what you’re talking about."
Recent global prosperity derived from a fortunate confluence of low inflation and low interest rates. In the 1980s, brutally high interest rates and recessions squeezed inflation out of the economy facilitating lower interest rates. Low energy prices, following the first Gulf War, helped keep inflation low and fuelled growth.
The fall of the Berlin Wall in 1989 and the reintegration of the command economies of Eastern Europe, China and India into global trade provided low cost labour helping maintain the supply of cheap goods and services. Emerging economies provided substantial new markets for products and capital driven by the very high levels of savings in these countries.
Deregulation of key industries, such as banking and telecommunications, fostered growth by increasing access to finance and improved essential infrastructure. Adoption of new technologies, such as information technology and the Internet, improved productivity and assisted growth, though the extent is disputed.
Many countries switched from employer or government pension schemes to private retirement saving arrangements underwritten by generous tax incentives. Rapid growth in this pool of investment capital was also a factor in growth.
Governments, irrespective of political persuasion, benefited from the favourable economic environment. The ability of governments and central banks to control and "fine tune" the economy with a judicial mixture of monetary and fiscal policy became an article of accepted faith. Voters were lulled into false confidence by a mixture of rising wealth, improved living standards and stability.
Elegant theories about the "Great Moderation" or "Goldilocks Economy", with the benefit of hindsight, seem to be little more than narrative fallacies where a convincing but meaningless story is shaped to fit unconnected facts and coincidence is confused with causality.
Ponzi Prosperity
Growth, in reality, was founded on a series of elegant Ponzi schemes.
Consumption rather than investment drove growth, particularly in the developed world. Debt fuelled consumption became the norm. In the new economy, there were three kinds of people – "the haves", "the have-nots", and "the have-not-paid-for-what-they-haves".
The consumption was financed by borrowings supplied by a deregulated financial system. Many workers’ earnings fell in inflation adjusted terms as a result of global competition and associated outsourcing and off shoring practices. The ability to borrow against the appreciation in owner occupied houses and other financial assets underpinned consumption.
Investors, central banks with large reserves, pension funds and asset managers channeling privatised retirement savings, eagerly purchased the debt. Borrowing fueled higher asset prices allowing even greater levels of borrowing against the value of the asset. This virtuous cycle – a "positive feedback loop" – fueled the "doctor feel good" economy of recent years.
"Financial engineering" replaced "real engineering" in many countries. Entire cities (London and New York) and economies (Iceland) become dominated by the rapidly growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10% in the early 1980s to 40% in 2007. The stockmarket value of financial services firms increased from 6% in the early 1980s to 23% in 2007.
The reliance on financial innovation proved disastrous. In A Short History of Financial Euphoria (1994), John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."
Financially engineered growth extended into international trade flows. Since the 1990s, there has been a substantial build-up of foreign reserves in central banks of emerging markets and developing countries that became the foundation for a trade finance scheme.
Many global currencies were pegged to the dollar at an artificially low rate, like the Chinese Renminbi, to maintain export competitiveness. This created an outflow of dollars (via the trade deficit driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers purchased US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flowed back to the US to finance the spending on imports.
The process relied on the historically unimpeachable credit quality of the USA and large, liquid markets in dollars and dollar investments capable of accommodating the very large investment requirements. This merry-go-round kept US interest rates and cost of capital low encouraging further borrowing to finance consumption and imports to keep the cycle going.
Foreign central banks holding reserves were lending the funds used to purchase goods from the country. The exporting nations never got paid at least until the loan to the buyer (the vendor finance) was paid off. Essentially, growth in global trade was also debt fuelled.
Moderate debt levels are sustainable provided the value of the asset supporting the borrowing is stable and significantly higher than the amount of the loan. The borrower or the collateral for the loan must generate sufficient income to service and repay the borrowing. In the frenzied market environment of low interest rates and ever rising asset prices, the level of collateral cover and ability to service the loans deteriorated sharply. In 2005, rising interest rates and a cooling in the US housing market set the stage for the GFC.
Sigmund Freud once remarked that: "Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces." The GFC was the reality on which the fake pleasure of the Great Moderation and Goldilocks economy was smashed.
Taking the Cure
There is currently confusion between the disease and the cure. The "disease" is the excessive debt and leverage in the financial system, especially in the US, Great Britain, Spain and Australia. The "cure" is the reduction of the level of debt that is now underway (the great "de-leveraging").
The initial phase of the cure is the reduction in debt within the financial system. Some of the debt created during the Ponzi prosperity years will not be repaid. Non-repayment of this debt, in turn, has caused the failure of financial institutions. The process destroys both existing debt and also limits the capacity for further credit creation by financial institutions.
Total losses from the GFC to financial institutions, according the latest estimates, will be in excess of US$ 2 trillion. Banks need additional capital to cover assets that were parked in the "shadow banking system" (the complex of off-balance sheet special purpose vehicles) but are now returning to the mother ship’s balance sheet. The global banking system, in aggregate, is close to technically insolvent.
Commercial sources for recapitalisation are limited as losses mount and the outlook for the financial services industry has deteriorated. Government ownership or de facto nationalisation is the only option to maintain a viable banking system in many countries.
Even after recapitalisation the capital shortfall in the global banking system is likely to be around US$ 1-3 trillion. This equates to a forced contraction in global credit of around 20-30% from existing levels.
The second phase of the cure is the effect on the real economy. The problems of the financial sector have increased the cost and reduced availability of debt to borrowers for legitimate business purposes. The scarcity of capital means that banks must reduce their balance sheets by reducing their stock of loans. Normal financing and loans are now being effectively rationed in global markets.
This forces corporations to reduce leverage by cutting costs, selling assets, reducing investment and raising equity. This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.
"Negative feedback loops" mean reduction in investment and consumption lowers economic activity, placing stresses on corporations and individuals setting off bankruptcies that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt.
Within the financial sector, de-leveraging is well advanced. In the real economy it is in the early stages. The process echoes Joseph Schumpter’s famous maxim of "creative destruction".
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
This article draws on the ideas first published in Satyajit Das "Built to Fail" in The Monthly (April 2009) 8-13
http://www.eurointelligence.com/article.581+M553774d2c37.0.html
27 February 2009
Eastern Europe Blowing Up
While investors are correctly paying a lot of attention to the programs being put out by the White house this week, just under the radar is the rapidly developing Eastern European situation that is threatening to exacerbate the world banking crisis. Last week Moody's rattled the markets a bit when it said it was considering downgrading a number of European banks because of severe problems with their loans to Eastern Europe. The concern immediately faded to the background, however, as it was overshadowed by the barrage of news coming out of Washington on the stimulus package, the banking situation, the mortgage programs and the proposed budget. We think that it won't be long before the Eastern Europe economic and financial distress will be a major topic on the front pages and cable news.
What's happening is that the economies of the Eastern European nations and ex-Soviet republics are crumbling at a time when they owe vast sums to European banks. On average, GDP in the Baltic countries is down 17% and their stock markets down 70%. Still, they have raised their short rates by 500 basis points to defend their currencies that are plunging, thereby making the economic situation even worse. In Poland, 60% of the mortgages are denominated in Swiss francs and the zloty has plunged against the franc. Their industrial production has declined 14.9%. In the Ukraine, GDP has dropped 20% year-over-year while industrial production has declined 34%. The Hungarian forint is down 30% against the euro, and almost all of their mortgages are denominated in foreign currencies, making them more difficult to service. The Hungarian stock market is down 60% and auto sales are off by 50%. Other Eastern European countries are facing similar situations.
The problem is that the aforementioned group of nations has borrowed $1.7 trillion from foreign countries, with $1.3 trillion of it from European banks. They must pay back or rollover $400 billion this year, an amount equivalent to one-third of the group's GDP. With credit markets frozen, however, this is an impossible task, and without a massive bailout, these countries will blow up. Especially vulnerable are banks in Austria, Sweden, Greece, Italy and Belgium. Austrian banks alone have exposure of $280 billion to emerging Europe, an amount equal to 64% of its GDP.
The European Bank for Reconstruction and Development (EBRD) estimated that the bad debts of Eastern Europe and the ex-Soviet republics would exceed 10% and possibly be as high as 20%. Hans Redeker, Chief Currency Strategist at PNB Paribas said, "We're nearing the level where things can get out of hand". IMF head Dominique Strauss-Kahn expects a "second wave of countries to come knocking" after prior IMF bailouts of Latvia, Hungary, Ukraine and Belarus. IMF reserves are rapidly running down after a series of aid packages to emerging nations.
Austrian Finance Minister Josef Proll is trying to put together a rescue package before the situation deteriorates further. Der Standard in Vienna said that "A failure rate of 10% would lead to the collapse of the Austrian financial sector". German Finance Minister Steinbruck said that the Western European governments may be forced to bail out Eastern Europe. With Western European economies already in terrible shape, this will not be accomplished without a lot of time and turmoil. It will be exceedingly difficult to get the various nations to agree on a package and the citizens of Western Europe will certainly protest at having to bail out foreign countries when they are having such a rough time themselves. We think this means some more significant downturns for global markets.
link
What's happening is that the economies of the Eastern European nations and ex-Soviet republics are crumbling at a time when they owe vast sums to European banks. On average, GDP in the Baltic countries is down 17% and their stock markets down 70%. Still, they have raised their short rates by 500 basis points to defend their currencies that are plunging, thereby making the economic situation even worse. In Poland, 60% of the mortgages are denominated in Swiss francs and the zloty has plunged against the franc. Their industrial production has declined 14.9%. In the Ukraine, GDP has dropped 20% year-over-year while industrial production has declined 34%. The Hungarian forint is down 30% against the euro, and almost all of their mortgages are denominated in foreign currencies, making them more difficult to service. The Hungarian stock market is down 60% and auto sales are off by 50%. Other Eastern European countries are facing similar situations.
The problem is that the aforementioned group of nations has borrowed $1.7 trillion from foreign countries, with $1.3 trillion of it from European banks. They must pay back or rollover $400 billion this year, an amount equivalent to one-third of the group's GDP. With credit markets frozen, however, this is an impossible task, and without a massive bailout, these countries will blow up. Especially vulnerable are banks in Austria, Sweden, Greece, Italy and Belgium. Austrian banks alone have exposure of $280 billion to emerging Europe, an amount equal to 64% of its GDP.
The European Bank for Reconstruction and Development (EBRD) estimated that the bad debts of Eastern Europe and the ex-Soviet republics would exceed 10% and possibly be as high as 20%. Hans Redeker, Chief Currency Strategist at PNB Paribas said, "We're nearing the level where things can get out of hand". IMF head Dominique Strauss-Kahn expects a "second wave of countries to come knocking" after prior IMF bailouts of Latvia, Hungary, Ukraine and Belarus. IMF reserves are rapidly running down after a series of aid packages to emerging nations.
Austrian Finance Minister Josef Proll is trying to put together a rescue package before the situation deteriorates further. Der Standard in Vienna said that "A failure rate of 10% would lead to the collapse of the Austrian financial sector". German Finance Minister Steinbruck said that the Western European governments may be forced to bail out Eastern Europe. With Western European economies already in terrible shape, this will not be accomplished without a lot of time and turmoil. It will be exceedingly difficult to get the various nations to agree on a package and the citizens of Western Europe will certainly protest at having to bail out foreign countries when they are having such a rough time themselves. We think this means some more significant downturns for global markets.
link
22 January 2009
Gordon Brown brings Britain to the edge of bankruptcy ~Telegraph
The country stands on the precipice. We are at risk of utter humiliation, of London becoming a Reykjavik on Thames and Britain going under. Thanks to the arrogance, hubristic strutting and serial incompetence of the Government and a group of bankers, the possibility of national bankruptcy is not unrealistic.
The political impact will be seismic; anger will rage. The haunted looks on the faces of those in supporting roles, such as the Chancellor, suggest they have worked out that a tragedy is unfolding here. Gordon Brown is engaged no longer in a standard battle for re-election; instead he is fighting to avoid going down in history disgraced completely.
This catastrophe happened on his watch, no matter how much he now opportunistically beats up on bankers. He turned on the fountain of cheap money and encouraged the country to swim in it. House prices rose, debt went through the roof and the illusion won elections. Throughout, Brown boasted of the beauty of his regulatory structure, when those in charge of it were failing to ask the most basic questions of financial institutions. The same bankers Brown now claims to be angry with, he once wooed, travelling to the City to give speeches praising their "financial innovation".
Does the Prime Minister realise the likely implications when the country joins the dots? He has never been wild on shouldering blame, so I doubt it. But Brown is a historian. He should know that when a nation has put all its chips on red and the ball lands on black, the person who made the call is responsible. Neville Chamberlain discovered this in May 1940 with the German invasion of France.
We're some way from a similar event. But do not underestimate the gravity of the emergency and potential for disgrace.
The Government's bail-out of the banks in October with £37 billion of taxpayers' money was supposed to have "saved the world", according to the PM, but now it is clear that it has not even saved the banks. Our money kept the show on the road for only three months.
As the Liberal Democrats' Treasury spokesman Vince Cable asks: where has the £37 billion gone? The answer, as Cable knows, is that it has disappeared down the plug hole.
It is finally dawning on the Government that the liabilities of the British banks grew to be so vast in the boom years that they now eclipse the entire economy. Unfortunately, the Treasury is pledged to honour those
liabilities because it has guaranteed not to let a British bank go down. RBS has liabilities of £1.8 trillion, three times annual UK government spending, against assets of £1.9 trillion. But after the events of the past year, I wager most taxpayers will believe the true picture is worse.
Meanwhile, the assets are falling in value. This matters, because post-nationalisation these liabilities are now yours and
mine.
And they come piled on top of the rocketing national debt, charitably put at £630 billion, or 43 per cent of GDP. The true figure is much higher because the Government has used off-balance sheet accounting to hide commitments such as PFI projects.
Add to that record consumer indebtedness and Britain becomes extremely vulnerable. The markets have worked this out ahead of the politicians, as usual, and are wondering what to do next. If they decide our nation is a basket case, they will make it so.
The PM and the Chancellor , both looking a year older every day, tell us that for their next trick they will buy more bank shares, create a giant insurance scheme for bad debt, pledge to honour liabilities without limit, cross their fingers and hope it all works. The phrase "bottomless pit" springs to mind for a reason: that is what they have designed.
In this gloom, the Prime Minister has but one slender hope: that somehow, by force of personality, the new President Obama engineers a rapid American recovery restoring global confidence, energising the markets and making us all forget this bad dream.
Obama is talented but he is not a magician. Instead, Gordon Brown's nightmare, in which we are all trapped, is going to get much worse.
The political impact will be seismic; anger will rage. The haunted looks on the faces of those in supporting roles, such as the Chancellor, suggest they have worked out that a tragedy is unfolding here. Gordon Brown is engaged no longer in a standard battle for re-election; instead he is fighting to avoid going down in history disgraced completely.
This catastrophe happened on his watch, no matter how much he now opportunistically beats up on bankers. He turned on the fountain of cheap money and encouraged the country to swim in it. House prices rose, debt went through the roof and the illusion won elections. Throughout, Brown boasted of the beauty of his regulatory structure, when those in charge of it were failing to ask the most basic questions of financial institutions. The same bankers Brown now claims to be angry with, he once wooed, travelling to the City to give speeches praising their "financial innovation".
Does the Prime Minister realise the likely implications when the country joins the dots? He has never been wild on shouldering blame, so I doubt it. But Brown is a historian. He should know that when a nation has put all its chips on red and the ball lands on black, the person who made the call is responsible. Neville Chamberlain discovered this in May 1940 with the German invasion of France.
We're some way from a similar event. But do not underestimate the gravity of the emergency and potential for disgrace.
The Government's bail-out of the banks in October with £37 billion of taxpayers' money was supposed to have "saved the world", according to the PM, but now it is clear that it has not even saved the banks. Our money kept the show on the road for only three months.
As the Liberal Democrats' Treasury spokesman Vince Cable asks: where has the £37 billion gone? The answer, as Cable knows, is that it has disappeared down the plug hole.
It is finally dawning on the Government that the liabilities of the British banks grew to be so vast in the boom years that they now eclipse the entire economy. Unfortunately, the Treasury is pledged to honour those
liabilities because it has guaranteed not to let a British bank go down. RBS has liabilities of £1.8 trillion, three times annual UK government spending, against assets of £1.9 trillion. But after the events of the past year, I wager most taxpayers will believe the true picture is worse.
Meanwhile, the assets are falling in value. This matters, because post-nationalisation these liabilities are now yours and
mine.
And they come piled on top of the rocketing national debt, charitably put at £630 billion, or 43 per cent of GDP. The true figure is much higher because the Government has used off-balance sheet accounting to hide commitments such as PFI projects.
Add to that record consumer indebtedness and Britain becomes extremely vulnerable. The markets have worked this out ahead of the politicians, as usual, and are wondering what to do next. If they decide our nation is a basket case, they will make it so.
The PM and the Chancellor , both looking a year older every day, tell us that for their next trick they will buy more bank shares, create a giant insurance scheme for bad debt, pledge to honour liabilities without limit, cross their fingers and hope it all works. The phrase "bottomless pit" springs to mind for a reason: that is what they have designed.
In this gloom, the Prime Minister has but one slender hope: that somehow, by force of personality, the new President Obama engineers a rapid American recovery restoring global confidence, energising the markets and making us all forget this bad dream.
Obama is talented but he is not a magician. Instead, Gordon Brown's nightmare, in which we are all trapped, is going to get much worse.
18 October 2008
The $58 Trillion Elephant in the Room
The $58 Trillion Elephant in the Room
by Jesse Eisinger | See Archive
The roots of this year’s financial crisis go back to a small team of bankers at J.P. Morgan in New York. Now, their invention—credit derivatives—has helped bring down Wall Street and has left Morgan with its biggest exposure of all.
At a time when the reputation of bankers has been shredded, Bill Demchak is a throwback. The day I meet him, the financial world is once again poised on the brink of destruction. The Dow Jones Industrial Average lost 358 points the day before and is already down another 150 this morning. Yet the green-eyed Demchak, in pleated khakis hiked up unfashionably high onhis waist, seems preternaturally calm—especially for a man who, unwittingly, has had a hand in bringing Wall Street to its knees.
Demchak, now the vice chairman of PNC Financial in Pittsburgh, returned to his hometown in 2002 to help rescue the bank after it became mired in an accounting scandal. Under Demchak and the rest of its new management team, PNC has avoided most of the terrible mistakes of its Wall Street peers by spurning bad mortgages, dubious off-balance-sheet deals, and questionable corporate loans. It’s now one of the best-performing banks in the country.
Jesse Eisinger
But before he had this life, Demchak had another, as the leader of a small group at J.P. Morgan in New York that pioneered the kind of financial instruments that eventually led to this autumn’s wreckage on Wall Street. The J.P. Morgan team created and then industrialized credit derivatives, which have enveloped the global markets, growing to a mind-numbing $58 trillion worth of credit contracts. They have spread and morphed in ways that Demchak never intended but always feared.
Long celebrated as a way for banks to diffuse their risks, the credit derivatives invented by Demchak’s team have instead multiplied them. The new credit vehicles encouraged banks and other financial firms to take on riskier loans than they should have; helped increase leverage in the global financial system; and exposed a much wider array of financial firms to the risk of default. (View an interactive timeline of derivatives.)
Credit derivatives aren’t, of course, solely to blame for the pandemic that has helped bring down Wall Street. They didn’t single-handedly force Bear Stearns and Lehman Brothers to bulk up on toxic debt, dooming them to collapse. But they made the financial world more complex and more opaque. Ultimately, they have exacerbated the market panic, as financial firms and regulators have belatedly come to grips with the enormity of the problems. Merrill Lynch ultimately capitulated to a sale because investors had no confidence that the firm had a handle on what its problems were. When the federal government took over A.I.G. in September, it was largely because of the insurance behemoth’s exposure to credit-default swaps, a type of derivative that flourished in the wake of Demchak and his team’s creations. By mid-September, Treasury Secretary Hank Paulson was forced into proposing the largest bailout in U.S. history. Securities and Exchange Commission chairman Christopher Cox (S.E.C. No Evil, October) called for regulating credit derivatives.
Morgan’s derivatives project began in the wake of the Asian financial crisis in 1997 as an attempt to protect the bank from bad loans. Demchak’s innovations worked—for his bank. Morgan came to dominate this corner of the financial world while preserving a culture of prudence. Morgan—deemed to be so safe that it snagged two of the victims of the financial-system collapse, Bear Stearns and Washington Mutual—is still swimming in credit derivatives, far more than any other firm on Wall Street, though the bank says it’s hedged. As of the second quarter of 2008, the bank had written derivatives contracts backing credit valued at $10.2 trillion, roughly three-quarters the size of the U.S. economy.
But Demchak’s innovation has a more troubling legacy. J.P. Morgan, rather than being inoculated, was actually becoming the Patient Zero of Wall Street, eventually carrying the credit virus to the far corners of the global financial system. The structure of the first derivatives deal wasn’t as solid as Demchak’s team had intended. That initial, flawed financial instrument was later replicated thousands of times by J.P. Morgan and other banks, with the same defects repeated and magnified over and over again.
The creation of credit derivatives, only a decade ago, is more responsible than anything else for binding the global financial world together more closely. Now some of the trailblazers are puzzling over what has been wrought. “How can we have a financial system so precariously balanced after such an extraordinarily profitable period?” asks Andrew Donaldson, a former colleague of Demchak’s who runs an asset management firm in London.
Demchak spends his days in an unassuming office in PNC’s headquarters, situated amid a slightly seedy collection of streets in downtown Pittsburgh. Demchak warned for years about excesses in lending and is now baffled by, and even somewhat contemptuous of, his peers’ disastrous mistakes: “At the end of the day, I’m never going to be—knock on wood—a guy you see in the paper and say, ‘Look at this stupid, self-serving decision.’ ”
Later, as he thinks back to 1997 and the days in New York when his team helped get the derivatives market off the ground, he lights up. “Oh, God,” Demchak says. “It was absolutely the best time ever in my life.”
In the mid-1990s, Demchak, along with his boss, Peter Hancock, an effervescent Briton, became converts to the closest thing the banking industry has had to a religious reformation. Back then, relationships drove the commercial-banking business. Glad-handing bankers with tight connections to corporate boardrooms made the rain.
These guys never met a loan from a corporate client they would turn down, even if they weren’t sure it would be profitable in the long run.
Hancock and Demchak’s creed was simple: Banks should know whether their loans were going to make money. The pair insisted that loans be priced to their current value in the market. Because of the legacy of the old relationship bankers, J.P. Morgan was struggling. The problem, in the view of the stock market, was that the bank had the wrong clients. They were sleepy American icons, some of whom John Pierpont Morgan himself had lent to and even helped build. Though bank officials were promising Wall Street that it could generate returns of 20 percent, the return on many of its loans was much lower, forcing the bank to run the race while dragging lead weights on its ankles.
The Asian financial crisis highlighted the problem. Morgan lost money on loans to Asian companies. That prompted the bank to take a look at all of its corporate lending practices, abroad as well as at home. When it did, top executives came to a sobering realization: Not only was J.P. Morgan not making nearly enough profit on these blue-chip corporate loans, the bank had also made far too many of them. Most weren’t loans at all but lines of credit promising funds at some later date. Hancock and Demchak realized that in a crisis, many of these companies would probably ask J.P. Morgan for access to the money they were promised. Worse, they wouldn’t do it unless they were on the brink of collapse—exactly the wrong time for a banker to make a loan. The bankers who made those loans thought the odds of that happening were too small to even consider. “The old banking mentality viewed them as riskless,” Demchak says. But the mentality was wrong.
Morgan realized it needed to act quickly to reduce its exposure. It had to free up capital for more profitable business. But it couldn’t sell the loans without alienating its longtime, blue-chip customers.
Demchak put the new religion into action. “Demchak was the first person I know of who had the vision that the credit-derivatives market could be anything like it is today,” says Charles Pardue, who worked for Demchak at J.P. Morgan before moving to a hedge fund in London.
Over the coming months, Demchak would put his assault team of math whizzes and marketers to work on fixing the problem. Within the bank, the project was called the Credit Transformation.
Demchak received crucial help from his lieutenant, Blythe Masters, a rising star and formidable presence at the bank. She interned at Morgan while still in college at Cambridge, in Britain, and joined the bank after graduating. Ultracompetitive and driven with a passion for debate, she would give talks and seminars proselytizing about the promise and power of credit derivatives, ultimately becoming their “poster child,” according to credit-markets consultant Eileen Murphy.
“When you are doing something new, it gets done only by imposing your force of will,” says a former colleague of Masters’. “She was that person.”
Wall Street likes to call its innovations “technologies” to convey a weighty sense of importance. What Demchak and Masters did was combine two of these technologies—securitization and credit derivatives—for the first time.
Securitization has been around since the 1970s. In such a transaction, a group of loans—for example, mortgage, credit card, or corporate loans—is bundled together and sliced up into pieces called tranches. The lowest portion, called the equity, is exposed to the first losses. The next slice up is exposed to the following losses, and so on, until you get to the top. The slices are usually rated by the rating agencies. (Often, the media and even some on Wall Street colloquially refer to tranches of securitizations as derivatives; they aren’t. Tranches are securities backed by a pool of cash-producing assets.)
The Demchak group’s breakthrough was to inject a little magic into standard securitizations. Instead of putting a particular loan into the sliced-up instrument—say, a 30-year loan to I.B.M.—it put a piece of J.P. Morgan’s exposure to I.B.M. into it. For this, the team used credit-default swaps, a burgeoning form of credit derivative. In a C.D.S. transaction, the buyer is protected against a default. These contracts had been floating around in small, experimental form for several years, having been created by Bankers Trust, a scrappy cowboy investment bank.
Demchak’s team was the first to take them wholesale, using credit-default swaps in a huge deal. They mashed up J.P. Morgan’s exposure to more than 300 giant corporations, created an off-balance-sheet vehicle, then sold slices of that to investors. The vehicle then protected J.P. Morgan from defaults. In effect, Morgan was paying insurance premiums to investors who now were on the hook if one of Morgan’s clients went belly-up. “The innovation of not being tied to specific loans or bonds is what made the credit-derivatives market what it is today,” says Romita Shetty, who was part of Demchak’s team at J.P. Morgan.
Development on the project continued slowly through the second half of 1997, involving painstaking and tedious legal and accounting work, quantitative analysis, and hand-holding and persuasion of banking regulators and credit-rating agencies. Demchak and Masters wanted their first deal to hit the market by the end of the year so that Morgan could get credit for it when the bank reported its earnings. The period was so intense that Masters, an avid equestrienne, at one point took a conference call from atop her horse.
Finally, in December 1997, Demchak’s team closed on this first big credit-derivatives deal, the Broad Indexed Secured Trust Offering, or Bistro for short. Insurance companies and banks, the initial customers, were enthusiastic, snapping it up in just two weeks. The deal was enormous for the time, off-loading more than $9.7 billion of J.P. Morgan’s exposure. Morgan had succeeded in reducing its balance-sheet risk and was able to free up capital to buy its stock back.
J.P. Morgan would go on to launch a credit-derivatives assembly line, becoming the Henry Ford of the new financial market. Throughout the 1990s, the bank was a major player in persuading lawmakers to allow the derivatives markets to remain unregulated—a move regulators are now reevaluating. Bistro helped J.P. Morgan traders in London kick-start the expansion of the “single-name” C.D.S. market, where individual contracts that cover just one company or entity trade hands. This market became liquid and deep by the early 2000s. “We had 100 people,” Demchak recalls. “We helped create the regulatory framework, the legal and accounting framework, and we did billions. We industrialized the product.”
J.P. Morgan continues to dominate the world of derivatives. It has derivatives contracts tied to $90 trillion of underlying securities. Of that, $10.2 trillion are credit-derivatives contracts. Those mind-boggling totals are somewhat misleading. They reflect what is called the “notional” amount in the world of derivatives, based on the underlying amount of the contract, not its current value. When offsetting contracts are taken into account, that figure is whittled down to a much smaller—though still enormous—$109 billion of derivatives, of which $26 billion are credit derivatives. That’s the amount the bank could lose if all its trading partners went out of business, an extremely remote event. But the exposure is climbing, up 17.4 percent from the end of 2007. That’s equal to 20 percent of the bank’s net worth.
Bistro “was the most sublime piece of financial engineering that was ever developed. It was breathtaking in terms of beauty and elegance,” says Satyajit Das, a risk consultant and the author of Traders, Guns, and Money, a financial history. But “in many ways,” Das adds, “J.P. Morgan created Frankenstein’s monster.”
F
or J.P. Morgan, Bistro worked wonderfully. But even in that first deal, the weaknesses in structured finance and credit derivatives that would come to the fore in the 2007 credit-market crash were already there.
Despite its blue-chip assets, Bistro didn’t perform pristinely. The initial slice, the equity layer that Morgan retained as a cushion against trouble, was so thin that it couldn’t weather even one default from one of the bigger companies in the bundle. That ultimately happened, wiping the slice out entirely. The investors who were one notch up, in what’s called the mezzanine layer, lost money as well. Even the buyers of the top-rated tranches, which were thought to be rock solid, had to endure bumpy periods before they got their money back.
During that first major deal, the credit-rating agencies, which were supposed to be impartial, were already deeply enmeshed in the give-and-take of the process. A former Morgan banker who helped create Bistro recalls that Standard & Poor’s was giving the bank a tough time. The rating firm would run the deal through its models, and “each time, it came up with disastrous results. We did some tinkering and all of a sudden, it could rate the deal,” the banker says.
The pattern was set. The rating agencies would become integral to the creation of the structures. Standard & Poor’s says questioning that first deal was appropriate and stands by its original rating. It further says it doesn’t get involved in structuring deals. But the close relationships between the rating agencies and the Wall Street firms were heavily criticized following widespread mortgage-related securities failures after the housing bubble burst.
After Bistro, investors and regulators embraced derivatives as ways to free up capital to make more loans. Banks around the world used the structures to off-load their own credit risk. Competitors rushed to copy Morgan and Bistro.
The knockoffs and followups were even more flawed than the original model. The second Bistro deal, in 1998, suffered credit downgrades. One of the big deals that followed fast on Bistro’s heels was York Funding, a Credit Suisse structure. “They stuffed it with the worst possible credits,” recalls a former rating-agency employee who examined the deal.
One major problem was that banks had the ability to substitute loans in and out of the structure, as long as the loans had the same credit rating. This allowed managers to scour their books for a loan that looked shaky but still retained a good credit rating and swap it in for a healthier one. The tranche’s credit rating would remain the same, making the whole deal look better on paper than it actually was.
Ultimately, the game became less about reducing risk and more about fooling regulators and the rating agencies. “From 1999 to 2000, there was a lot of innovation for innovation’s sake. A lot of products game the rating agencies and game the regulatory capital requirements,” says a former J.P. Morgan banker who was involved with Bistro.
Warning signs piled up. After the tech bubble burst in 2000, myriad similar deals performed terribly. Some were backed by corporate loans. Many were Bistro-like constructs with credit derivatives. As a class, they hadn’t made it through a cycle of corporate defaults profitably, the acid test of any stable credit product. In his recounting of the period, Das writes, “The credit models failed miserably.”
Despite the obvious failure of the first round of this wizardry, Wall Street was at it again by 2003, this time with mortgages. Investment banks sold billions of structured securities, made up mostly of housing loans to subprime customers with shaky credit. As the market got going, Wall Street bundled leveraged loans made to companies that had junk ratings from the credit-rating agencies. At the peak in 2006, Wall Street issued $89 billion worth of Bistro-like structures called synthetic collateralized-debt obligations. Many of the $415 billion worth of the main type of C.D.O. carried embedded credit derivatives as well.
It’s not surprising that they failed again. Investors and financial firms lost hundreds of billions of dollars as part of the housing and corporate loan meltdown. Only then did the credit-rating agencies come under assault for being too closely involved in helping Wall Street create the complex structures. It took until this year for the structured-finance market to come to a screeching halt.
T
oday, the financial markets are living in the slipstream of the Bistro deal. “People like to talk about what a shambles the banking system is. But it’s a shambles by design. You are taking on capital, reserving some of it, and lending it out. The whole system is levered,” says a former J.P. Morgan banker. After Bistro, it became more so.
The practice of crafting loans that banks had no intention of keeping on their own balance sheets wasn’t invented by J.P. Morgan, nor was the credit-derivatives market solely responsible for making it possible. Certainly, not all the lending excesses, especially in mortgages, can be laid at the feet of the complex Wall Street structures that used derivatives. But Bistro spread the popularity of this “originate and distribute” model. This experience taught the banking industry that loans designed to be sold to investors for a quick profit performed much more poorly than loans that banks had to keep.
In addition to keeping the very small piece of Bistro’s first-loss equity slice, J.P. Morgan retained part of the very top slice. Demchak’s team christened it “supersenior.” His group knew that there were risks, though slight, in keeping exposure to these slices. A.I.G., Merrill Lynch, and bond insurers MBIA and Ambac ignored them. Knowingly or not, these firms followed the Bistro deal, retaining supersenior exposure on their books to billions of dollars’ worth of structures in recent years. These companies thought—erroneously—that the slices were so unlikely to default that they needn’t set aside much capital for that eventuality.
The problem was that the underlying assets propping these slices up weren’t blue-chip loans but rather loans to subprime borrowers and junk companies. The supersenior slices turned out to be enormously risky, exposing these companies to huge losses.
Bankers have lost their heads in the past several years. The financial system has run amok. When the federal government took control of mortgage giants Fannie Mae and Freddie Mac, the takeover was deemed a “credit event,” triggering the credit-default swaps that other companies held as insurance against such an event. A week later, Lehman filed for bankruptcy, shrouding the market in an even greater fog. And then, investors in A.I.G. panicked. The insurance giant had written hundreds of billions of dollars’ worth of protection on the supersenior slices of mortgage-backed securities. Because of its high credit rating, A.I.G. hadn’t needed to post any initial collateral. But as the market sent the cost of default protection soaring, A.I.G.’s trading partners demanded collateral from the insurer. A.I.G. didn’t have it. Credit-rating agencies downgraded the insurance company, requiring that it post even more collateral. This left A.I.G. teetering on the edge of bankruptcy, and in an unprecedented intervention, it had to be nationalized by the federal government. For the first time, the C.D.S. market shrank in the first half of the year, after doubling every year since 2001.
Bistro had tied the world together, taking credit risk from the banks and passing it on to anyone who wanted it. For years, proponents of credit derivatives, including then-Federal Reserve chairman Alan Greenspan and current chair Ben Bernanke, had celebrated the way they spread risk. Everyone might share a little bit of risk, but no firm would collapse from it. Yet in this credit crisis, everyone has become infected.
Y
ou can almost detect a crisis of faith in Demchak. In the past eight years, he’s seen one market failure after another. First came the Chase takeover of J.P. Morgan. Chase’s stock soared in the ’90s as investors credulously rewarded its growth. Although it was able to take over the languishing J.P. Morgan, Chase had exposure to almost every big blowup in the wake of the bursting of the 1990s stock market bubble. Much of Demchak’s good work to off-load risk was for naught. (After Demchak left J.P. Morgan in 2002, almost every member of his team followed except Masters, who now runs the bank’s commodities businesses and is regarded as a possible C.E.O. candidate one day.)
Then the credit markets ran wild, with bankers handing out loans that Demchak knew could never be profitable. Today, the markets are gripped with what he sees as an oft-irrational panic, driving prices to fluctuate wildly.
Since Ronald Reagan’s presidency, the dominant ideology governing the financial world has been what George Soros calls “market fundamentalism”—the belief that we should trust the market when deciding how to allocate our resources. We’ll all be better off, the argument goes, if capital is allowed to flow wherever the prices call for it, with as little central planning and governmental interference as possible.
But we have had two great investment bubbles, first in the stock market and now in the credit markets. For the first time in a generation, even some bankers question whether the markets know anything. If they can’t be trusted, what’s going to replace them?
“I used to be the biggest advocate of marking everything to market at all times, because it keeps everyone honest,” Demchak says, referring to the practice of recording the value on the books at the current value. But he saw markets overreacting, swinging from euphoria to pessimism. Now he thinks the fates of great companies are in the hands of inexperienced traders speculating in thin markets. A colleague complained to Demchak recently that “some 24-year-old kid is going to mark me down or up 100 million bucks today. How is that?”
Demchak understands his colleague’s frustration. “He is right.”
by Jesse Eisinger | See Archive
The roots of this year’s financial crisis go back to a small team of bankers at J.P. Morgan in New York. Now, their invention—credit derivatives—has helped bring down Wall Street and has left Morgan with its biggest exposure of all.
At a time when the reputation of bankers has been shredded, Bill Demchak is a throwback. The day I meet him, the financial world is once again poised on the brink of destruction. The Dow Jones Industrial Average lost 358 points the day before and is already down another 150 this morning. Yet the green-eyed Demchak, in pleated khakis hiked up unfashionably high onhis waist, seems preternaturally calm—especially for a man who, unwittingly, has had a hand in bringing Wall Street to its knees.
Demchak, now the vice chairman of PNC Financial in Pittsburgh, returned to his hometown in 2002 to help rescue the bank after it became mired in an accounting scandal. Under Demchak and the rest of its new management team, PNC has avoided most of the terrible mistakes of its Wall Street peers by spurning bad mortgages, dubious off-balance-sheet deals, and questionable corporate loans. It’s now one of the best-performing banks in the country.
Jesse Eisinger
But before he had this life, Demchak had another, as the leader of a small group at J.P. Morgan in New York that pioneered the kind of financial instruments that eventually led to this autumn’s wreckage on Wall Street. The J.P. Morgan team created and then industrialized credit derivatives, which have enveloped the global markets, growing to a mind-numbing $58 trillion worth of credit contracts. They have spread and morphed in ways that Demchak never intended but always feared.
Long celebrated as a way for banks to diffuse their risks, the credit derivatives invented by Demchak’s team have instead multiplied them. The new credit vehicles encouraged banks and other financial firms to take on riskier loans than they should have; helped increase leverage in the global financial system; and exposed a much wider array of financial firms to the risk of default. (View an interactive timeline of derivatives.)
Credit derivatives aren’t, of course, solely to blame for the pandemic that has helped bring down Wall Street. They didn’t single-handedly force Bear Stearns and Lehman Brothers to bulk up on toxic debt, dooming them to collapse. But they made the financial world more complex and more opaque. Ultimately, they have exacerbated the market panic, as financial firms and regulators have belatedly come to grips with the enormity of the problems. Merrill Lynch ultimately capitulated to a sale because investors had no confidence that the firm had a handle on what its problems were. When the federal government took over A.I.G. in September, it was largely because of the insurance behemoth’s exposure to credit-default swaps, a type of derivative that flourished in the wake of Demchak and his team’s creations. By mid-September, Treasury Secretary Hank Paulson was forced into proposing the largest bailout in U.S. history. Securities and Exchange Commission chairman Christopher Cox (S.E.C. No Evil, October) called for regulating credit derivatives.
Morgan’s derivatives project began in the wake of the Asian financial crisis in 1997 as an attempt to protect the bank from bad loans. Demchak’s innovations worked—for his bank. Morgan came to dominate this corner of the financial world while preserving a culture of prudence. Morgan—deemed to be so safe that it snagged two of the victims of the financial-system collapse, Bear Stearns and Washington Mutual—is still swimming in credit derivatives, far more than any other firm on Wall Street, though the bank says it’s hedged. As of the second quarter of 2008, the bank had written derivatives contracts backing credit valued at $10.2 trillion, roughly three-quarters the size of the U.S. economy.
But Demchak’s innovation has a more troubling legacy. J.P. Morgan, rather than being inoculated, was actually becoming the Patient Zero of Wall Street, eventually carrying the credit virus to the far corners of the global financial system. The structure of the first derivatives deal wasn’t as solid as Demchak’s team had intended. That initial, flawed financial instrument was later replicated thousands of times by J.P. Morgan and other banks, with the same defects repeated and magnified over and over again.
The creation of credit derivatives, only a decade ago, is more responsible than anything else for binding the global financial world together more closely. Now some of the trailblazers are puzzling over what has been wrought. “How can we have a financial system so precariously balanced after such an extraordinarily profitable period?” asks Andrew Donaldson, a former colleague of Demchak’s who runs an asset management firm in London.
Demchak spends his days in an unassuming office in PNC’s headquarters, situated amid a slightly seedy collection of streets in downtown Pittsburgh. Demchak warned for years about excesses in lending and is now baffled by, and even somewhat contemptuous of, his peers’ disastrous mistakes: “At the end of the day, I’m never going to be—knock on wood—a guy you see in the paper and say, ‘Look at this stupid, self-serving decision.’ ”
Later, as he thinks back to 1997 and the days in New York when his team helped get the derivatives market off the ground, he lights up. “Oh, God,” Demchak says. “It was absolutely the best time ever in my life.”
In the mid-1990s, Demchak, along with his boss, Peter Hancock, an effervescent Briton, became converts to the closest thing the banking industry has had to a religious reformation. Back then, relationships drove the commercial-banking business. Glad-handing bankers with tight connections to corporate boardrooms made the rain.
These guys never met a loan from a corporate client they would turn down, even if they weren’t sure it would be profitable in the long run.
Hancock and Demchak’s creed was simple: Banks should know whether their loans were going to make money. The pair insisted that loans be priced to their current value in the market. Because of the legacy of the old relationship bankers, J.P. Morgan was struggling. The problem, in the view of the stock market, was that the bank had the wrong clients. They were sleepy American icons, some of whom John Pierpont Morgan himself had lent to and even helped build. Though bank officials were promising Wall Street that it could generate returns of 20 percent, the return on many of its loans was much lower, forcing the bank to run the race while dragging lead weights on its ankles.
The Asian financial crisis highlighted the problem. Morgan lost money on loans to Asian companies. That prompted the bank to take a look at all of its corporate lending practices, abroad as well as at home. When it did, top executives came to a sobering realization: Not only was J.P. Morgan not making nearly enough profit on these blue-chip corporate loans, the bank had also made far too many of them. Most weren’t loans at all but lines of credit promising funds at some later date. Hancock and Demchak realized that in a crisis, many of these companies would probably ask J.P. Morgan for access to the money they were promised. Worse, they wouldn’t do it unless they were on the brink of collapse—exactly the wrong time for a banker to make a loan. The bankers who made those loans thought the odds of that happening were too small to even consider. “The old banking mentality viewed them as riskless,” Demchak says. But the mentality was wrong.
Morgan realized it needed to act quickly to reduce its exposure. It had to free up capital for more profitable business. But it couldn’t sell the loans without alienating its longtime, blue-chip customers.
Demchak put the new religion into action. “Demchak was the first person I know of who had the vision that the credit-derivatives market could be anything like it is today,” says Charles Pardue, who worked for Demchak at J.P. Morgan before moving to a hedge fund in London.
Over the coming months, Demchak would put his assault team of math whizzes and marketers to work on fixing the problem. Within the bank, the project was called the Credit Transformation.
Demchak received crucial help from his lieutenant, Blythe Masters, a rising star and formidable presence at the bank. She interned at Morgan while still in college at Cambridge, in Britain, and joined the bank after graduating. Ultracompetitive and driven with a passion for debate, she would give talks and seminars proselytizing about the promise and power of credit derivatives, ultimately becoming their “poster child,” according to credit-markets consultant Eileen Murphy.
“When you are doing something new, it gets done only by imposing your force of will,” says a former colleague of Masters’. “She was that person.”
Wall Street likes to call its innovations “technologies” to convey a weighty sense of importance. What Demchak and Masters did was combine two of these technologies—securitization and credit derivatives—for the first time.
Securitization has been around since the 1970s. In such a transaction, a group of loans—for example, mortgage, credit card, or corporate loans—is bundled together and sliced up into pieces called tranches. The lowest portion, called the equity, is exposed to the first losses. The next slice up is exposed to the following losses, and so on, until you get to the top. The slices are usually rated by the rating agencies. (Often, the media and even some on Wall Street colloquially refer to tranches of securitizations as derivatives; they aren’t. Tranches are securities backed by a pool of cash-producing assets.)
The Demchak group’s breakthrough was to inject a little magic into standard securitizations. Instead of putting a particular loan into the sliced-up instrument—say, a 30-year loan to I.B.M.—it put a piece of J.P. Morgan’s exposure to I.B.M. into it. For this, the team used credit-default swaps, a burgeoning form of credit derivative. In a C.D.S. transaction, the buyer is protected against a default. These contracts had been floating around in small, experimental form for several years, having been created by Bankers Trust, a scrappy cowboy investment bank.
Demchak’s team was the first to take them wholesale, using credit-default swaps in a huge deal. They mashed up J.P. Morgan’s exposure to more than 300 giant corporations, created an off-balance-sheet vehicle, then sold slices of that to investors. The vehicle then protected J.P. Morgan from defaults. In effect, Morgan was paying insurance premiums to investors who now were on the hook if one of Morgan’s clients went belly-up. “The innovation of not being tied to specific loans or bonds is what made the credit-derivatives market what it is today,” says Romita Shetty, who was part of Demchak’s team at J.P. Morgan.
Development on the project continued slowly through the second half of 1997, involving painstaking and tedious legal and accounting work, quantitative analysis, and hand-holding and persuasion of banking regulators and credit-rating agencies. Demchak and Masters wanted their first deal to hit the market by the end of the year so that Morgan could get credit for it when the bank reported its earnings. The period was so intense that Masters, an avid equestrienne, at one point took a conference call from atop her horse.
Finally, in December 1997, Demchak’s team closed on this first big credit-derivatives deal, the Broad Indexed Secured Trust Offering, or Bistro for short. Insurance companies and banks, the initial customers, were enthusiastic, snapping it up in just two weeks. The deal was enormous for the time, off-loading more than $9.7 billion of J.P. Morgan’s exposure. Morgan had succeeded in reducing its balance-sheet risk and was able to free up capital to buy its stock back.
J.P. Morgan would go on to launch a credit-derivatives assembly line, becoming the Henry Ford of the new financial market. Throughout the 1990s, the bank was a major player in persuading lawmakers to allow the derivatives markets to remain unregulated—a move regulators are now reevaluating. Bistro helped J.P. Morgan traders in London kick-start the expansion of the “single-name” C.D.S. market, where individual contracts that cover just one company or entity trade hands. This market became liquid and deep by the early 2000s. “We had 100 people,” Demchak recalls. “We helped create the regulatory framework, the legal and accounting framework, and we did billions. We industrialized the product.”
J.P. Morgan continues to dominate the world of derivatives. It has derivatives contracts tied to $90 trillion of underlying securities. Of that, $10.2 trillion are credit-derivatives contracts. Those mind-boggling totals are somewhat misleading. They reflect what is called the “notional” amount in the world of derivatives, based on the underlying amount of the contract, not its current value. When offsetting contracts are taken into account, that figure is whittled down to a much smaller—though still enormous—$109 billion of derivatives, of which $26 billion are credit derivatives. That’s the amount the bank could lose if all its trading partners went out of business, an extremely remote event. But the exposure is climbing, up 17.4 percent from the end of 2007. That’s equal to 20 percent of the bank’s net worth.
Bistro “was the most sublime piece of financial engineering that was ever developed. It was breathtaking in terms of beauty and elegance,” says Satyajit Das, a risk consultant and the author of Traders, Guns, and Money, a financial history. But “in many ways,” Das adds, “J.P. Morgan created Frankenstein’s monster.”
F
or J.P. Morgan, Bistro worked wonderfully. But even in that first deal, the weaknesses in structured finance and credit derivatives that would come to the fore in the 2007 credit-market crash were already there.
Despite its blue-chip assets, Bistro didn’t perform pristinely. The initial slice, the equity layer that Morgan retained as a cushion against trouble, was so thin that it couldn’t weather even one default from one of the bigger companies in the bundle. That ultimately happened, wiping the slice out entirely. The investors who were one notch up, in what’s called the mezzanine layer, lost money as well. Even the buyers of the top-rated tranches, which were thought to be rock solid, had to endure bumpy periods before they got their money back.
During that first major deal, the credit-rating agencies, which were supposed to be impartial, were already deeply enmeshed in the give-and-take of the process. A former Morgan banker who helped create Bistro recalls that Standard & Poor’s was giving the bank a tough time. The rating firm would run the deal through its models, and “each time, it came up with disastrous results. We did some tinkering and all of a sudden, it could rate the deal,” the banker says.
The pattern was set. The rating agencies would become integral to the creation of the structures. Standard & Poor’s says questioning that first deal was appropriate and stands by its original rating. It further says it doesn’t get involved in structuring deals. But the close relationships between the rating agencies and the Wall Street firms were heavily criticized following widespread mortgage-related securities failures after the housing bubble burst.
After Bistro, investors and regulators embraced derivatives as ways to free up capital to make more loans. Banks around the world used the structures to off-load their own credit risk. Competitors rushed to copy Morgan and Bistro.
The knockoffs and followups were even more flawed than the original model. The second Bistro deal, in 1998, suffered credit downgrades. One of the big deals that followed fast on Bistro’s heels was York Funding, a Credit Suisse structure. “They stuffed it with the worst possible credits,” recalls a former rating-agency employee who examined the deal.
One major problem was that banks had the ability to substitute loans in and out of the structure, as long as the loans had the same credit rating. This allowed managers to scour their books for a loan that looked shaky but still retained a good credit rating and swap it in for a healthier one. The tranche’s credit rating would remain the same, making the whole deal look better on paper than it actually was.
Ultimately, the game became less about reducing risk and more about fooling regulators and the rating agencies. “From 1999 to 2000, there was a lot of innovation for innovation’s sake. A lot of products game the rating agencies and game the regulatory capital requirements,” says a former J.P. Morgan banker who was involved with Bistro.
Warning signs piled up. After the tech bubble burst in 2000, myriad similar deals performed terribly. Some were backed by corporate loans. Many were Bistro-like constructs with credit derivatives. As a class, they hadn’t made it through a cycle of corporate defaults profitably, the acid test of any stable credit product. In his recounting of the period, Das writes, “The credit models failed miserably.”
Despite the obvious failure of the first round of this wizardry, Wall Street was at it again by 2003, this time with mortgages. Investment banks sold billions of structured securities, made up mostly of housing loans to subprime customers with shaky credit. As the market got going, Wall Street bundled leveraged loans made to companies that had junk ratings from the credit-rating agencies. At the peak in 2006, Wall Street issued $89 billion worth of Bistro-like structures called synthetic collateralized-debt obligations. Many of the $415 billion worth of the main type of C.D.O. carried embedded credit derivatives as well.
It’s not surprising that they failed again. Investors and financial firms lost hundreds of billions of dollars as part of the housing and corporate loan meltdown. Only then did the credit-rating agencies come under assault for being too closely involved in helping Wall Street create the complex structures. It took until this year for the structured-finance market to come to a screeching halt.
T
oday, the financial markets are living in the slipstream of the Bistro deal. “People like to talk about what a shambles the banking system is. But it’s a shambles by design. You are taking on capital, reserving some of it, and lending it out. The whole system is levered,” says a former J.P. Morgan banker. After Bistro, it became more so.
The practice of crafting loans that banks had no intention of keeping on their own balance sheets wasn’t invented by J.P. Morgan, nor was the credit-derivatives market solely responsible for making it possible. Certainly, not all the lending excesses, especially in mortgages, can be laid at the feet of the complex Wall Street structures that used derivatives. But Bistro spread the popularity of this “originate and distribute” model. This experience taught the banking industry that loans designed to be sold to investors for a quick profit performed much more poorly than loans that banks had to keep.
In addition to keeping the very small piece of Bistro’s first-loss equity slice, J.P. Morgan retained part of the very top slice. Demchak’s team christened it “supersenior.” His group knew that there were risks, though slight, in keeping exposure to these slices. A.I.G., Merrill Lynch, and bond insurers MBIA and Ambac ignored them. Knowingly or not, these firms followed the Bistro deal, retaining supersenior exposure on their books to billions of dollars’ worth of structures in recent years. These companies thought—erroneously—that the slices were so unlikely to default that they needn’t set aside much capital for that eventuality.
The problem was that the underlying assets propping these slices up weren’t blue-chip loans but rather loans to subprime borrowers and junk companies. The supersenior slices turned out to be enormously risky, exposing these companies to huge losses.
Bankers have lost their heads in the past several years. The financial system has run amok. When the federal government took control of mortgage giants Fannie Mae and Freddie Mac, the takeover was deemed a “credit event,” triggering the credit-default swaps that other companies held as insurance against such an event. A week later, Lehman filed for bankruptcy, shrouding the market in an even greater fog. And then, investors in A.I.G. panicked. The insurance giant had written hundreds of billions of dollars’ worth of protection on the supersenior slices of mortgage-backed securities. Because of its high credit rating, A.I.G. hadn’t needed to post any initial collateral. But as the market sent the cost of default protection soaring, A.I.G.’s trading partners demanded collateral from the insurer. A.I.G. didn’t have it. Credit-rating agencies downgraded the insurance company, requiring that it post even more collateral. This left A.I.G. teetering on the edge of bankruptcy, and in an unprecedented intervention, it had to be nationalized by the federal government. For the first time, the C.D.S. market shrank in the first half of the year, after doubling every year since 2001.
Bistro had tied the world together, taking credit risk from the banks and passing it on to anyone who wanted it. For years, proponents of credit derivatives, including then-Federal Reserve chairman Alan Greenspan and current chair Ben Bernanke, had celebrated the way they spread risk. Everyone might share a little bit of risk, but no firm would collapse from it. Yet in this credit crisis, everyone has become infected.
Y
ou can almost detect a crisis of faith in Demchak. In the past eight years, he’s seen one market failure after another. First came the Chase takeover of J.P. Morgan. Chase’s stock soared in the ’90s as investors credulously rewarded its growth. Although it was able to take over the languishing J.P. Morgan, Chase had exposure to almost every big blowup in the wake of the bursting of the 1990s stock market bubble. Much of Demchak’s good work to off-load risk was for naught. (After Demchak left J.P. Morgan in 2002, almost every member of his team followed except Masters, who now runs the bank’s commodities businesses and is regarded as a possible C.E.O. candidate one day.)
Then the credit markets ran wild, with bankers handing out loans that Demchak knew could never be profitable. Today, the markets are gripped with what he sees as an oft-irrational panic, driving prices to fluctuate wildly.
Since Ronald Reagan’s presidency, the dominant ideology governing the financial world has been what George Soros calls “market fundamentalism”—the belief that we should trust the market when deciding how to allocate our resources. We’ll all be better off, the argument goes, if capital is allowed to flow wherever the prices call for it, with as little central planning and governmental interference as possible.
But we have had two great investment bubbles, first in the stock market and now in the credit markets. For the first time in a generation, even some bankers question whether the markets know anything. If they can’t be trusted, what’s going to replace them?
“I used to be the biggest advocate of marking everything to market at all times, because it keeps everyone honest,” Demchak says, referring to the practice of recording the value on the books at the current value. But he saw markets overreacting, swinging from euphoria to pessimism. Now he thinks the fates of great companies are in the hands of inexperienced traders speculating in thin markets. A colleague complained to Demchak recently that “some 24-year-old kid is going to mark me down or up 100 million bucks today. How is that?”
Demchak understands his colleague’s frustration. “He is right.”
13 October 2008
The Rise of the Machines: NYT opinion
“BEWARE of geeks bearing formulas.” So saith Warren Buffett, the Wizard of Omaha. Words to bear in mind as we bail out banks and buy up mortgages and tweak interest rates and nothing, nothing seems to make any difference on Wall Street or Main Street. Years ago, Mr. Buffett called derivatives “weapons of financial mass destruction” — an apt metaphor considering that the Manhattan Project’s math and physics geeks bearing formulas brought us the original weapon of mass destruction, at Trinity in New Mexico on July 16, 1945.
In a 1981 documentary called “The Day After Trinity,” Freeman Dyson, a reigning gray eminence of math and theoretical physics, as well as an ardent proponent of nuclear disarmament, described the seductive power that brought us the ability to create atomic energy out of nothing.
“I have felt it myself,” he warned. “The glitter of nuclear weapons. It is irresistible if you come to them as a scientist. To feel it’s there in your hands, to release this energy that fuels the stars, to let it do your bidding. To perform these miracles, to lift a million tons of rock into the sky. It is something that gives people an illusion of illimitable power, and it is, in some ways, responsible for all our troubles — this, what you might call technical arrogance, that overcomes people when they see what they can do with their minds.”
The Wall Street geeks, the quantitative analysts (“quants”) and masters of “algo trading” probably felt the same irresistible lure of “illimitable power” when they discovered “evolutionary algorithms” that allowed them to create vast empires of wealth by deriving the dependence structures of portfolio credit derivatives.
What does that mean? You’ll never know. Over and over again, financial experts and wonkish talking heads endeavor to explain these mysterious, “toxic” financial instruments to us lay folk. Over and over, they ignobly fail, because we all know that no one understands credit default obligations and derivatives, except perhaps Mr. Buffett and the computers who created them.
Somehow the genius quants — the best and brightest geeks Wall Street firms could buy — fed $1 trillion in subprime mortgage debt into their supercomputers, added some derivatives, massaged the arrangements with computer algorithms and — poof! — created $62 trillion in imaginary wealth. It’s not much of a stretch to imagine that all of that imaginary wealth is locked up somewhere inside the computers, and that we humans, led by the silverback males of the financial world, Ben Bernanke and Henry Paulson, are frantically beseeching the monolith for answers. Or maybe we are lost in space, with Dave the astronaut pleading, “Open the bank vault doors, Hal.”
As the current financial crisis spreads (like a computer virus) on the earth’s nervous system (the Internet), it’s worth asking if we have somehow managed to colossally outsmart ourselves using computers. After all, the Wall Street titans loved swaps and derivatives because they were totally unregulated by humans. That left nobody but the machines in charge.
How fitting then, that almost 30 years after Freeman Dyson described the almost unspeakable urges of the nuclear geeks creating illimitable energy out of equations, his son, George Dyson, has written an essay (published at Edge.org) warning about a different strain of technical arrogance that has brought the entire planet to the brink of financial destruction. George Dyson is an historian of technology and the author of “Darwin Among the Machines,” a book that warned us a decade ago that it was only a matter of time before technology out-evolves us and takes over.
His new essay — “Economic Dis-Equilibrium: Can You Have Your House and Spend It Too?” — begins with a history of “stock,” originally a stick of hazel, willow or alder wood, inscribed with notches indicating monetary amounts and dates. When funds were transferred, the stick was split into identical halves — with one side going to the depositor and the other to the party safeguarding the money — and represented proof positive that gold had been deposited somewhere to back it up. That was good enough for 600 years, until we decided that we needed more speed and efficiency.
Making money, it seems, is all about the velocity of moving it around, so that it can exist in Hong Kong one moment and Wall Street a split second later. “The unlimited replication of information is generally a public good,” George Dyson writes. “The problem starts, as the current crisis demonstrates, when unregulated replication is applied to money itself. Highly complex computer-generated financial instruments (known as derivatives) are being produced, not from natural factors of production or other goods, but purely from other financial instruments.”
It was easy enough for us humans to understand a stick or a dollar bill when it was backed by something tangible somewhere, but only computers can understand and derive a correlation structure from observed collateralized debt obligation tranche spreads. Which leads us to the next question: Just how much of the world’s financial stability now lies in the “hands” of computerized trading algorithms?
•
Here’s a frightening party trick that I learned from the futurist Ray Kurzweil. Read this excerpt and then I’ll tell you who wrote it:
But we are suggesting neither that the human race would voluntarily turn power over to the machines nor that the machines would willfully seize power. What we do suggest is that the human race might easily permit itself to drift into a position of such dependence on the machines that it would have no practical choice but to accept all of the machines’ decisions. ... Eventually a stage may be reached at which the decisions necessary to keep the system running will be so complex that human beings will be incapable of making them intelligently. At that stage the machines will be in effective control. People won’t be able to just turn the machines off, because they will be so dependent on them that turning them off would amount to suicide.
Brace yourself. It comes from the Unabomber’s manifesto.
Yes, Theodore Kaczinski was a homicidal psychopath and a paranoid kook, but he was also a bloodhound when it came to scenting all of the horrors technology holds in store for us. Hence his mission to kill technologists before machines commenced what he believed would be their inevitable reign of terror.
•
We are living, we have long been told, in the Information Age. Yet now we are faced with the sickening suspicion that technology has run ahead of us. Man is a fire-stealing animal, and we can’t help building machines and machine intelligences, even if, from time to time, we use them not only to outsmart ourselves but to bring us right up to the doorstep of Doom.
We are still fearful, superstitious and all-too-human creatures. At times, we forget the magnitude of the havoc we can wreak by off-loading our minds onto super-intelligent machines, that is, until they run away from us, like mad sorcerers’ apprentices, and drag us up to the precipice for a look down into the abyss.
As the financial experts all over the world use machines to unwind Gordian knots of financial arrangements so complex that only machines can make — “derive” — and trade them, we have to wonder: Are we living in a bad sci-fi movie? Is the Matrix made of credit default swaps?
When Treasury Secretary Paulson (looking very much like a frightened primate) came to Congress seeking an emergency loan, Senator Jon Tester of Montana, a Democrat still living on his family homestead, asked him: “I’m a dirt farmer. Why do we have one week to determine that $700 billion has to be appropriated or this country’s financial system goes down the pipes?”
“Well, sir,” Mr. Paulson could well have responded, “the computers have demanded it.”
Richard Dooling is the author of “Rapture for the Geeks: When A.I. Outsmarts I.Q.”
In a 1981 documentary called “The Day After Trinity,” Freeman Dyson, a reigning gray eminence of math and theoretical physics, as well as an ardent proponent of nuclear disarmament, described the seductive power that brought us the ability to create atomic energy out of nothing.
“I have felt it myself,” he warned. “The glitter of nuclear weapons. It is irresistible if you come to them as a scientist. To feel it’s there in your hands, to release this energy that fuels the stars, to let it do your bidding. To perform these miracles, to lift a million tons of rock into the sky. It is something that gives people an illusion of illimitable power, and it is, in some ways, responsible for all our troubles — this, what you might call technical arrogance, that overcomes people when they see what they can do with their minds.”
The Wall Street geeks, the quantitative analysts (“quants”) and masters of “algo trading” probably felt the same irresistible lure of “illimitable power” when they discovered “evolutionary algorithms” that allowed them to create vast empires of wealth by deriving the dependence structures of portfolio credit derivatives.
What does that mean? You’ll never know. Over and over again, financial experts and wonkish talking heads endeavor to explain these mysterious, “toxic” financial instruments to us lay folk. Over and over, they ignobly fail, because we all know that no one understands credit default obligations and derivatives, except perhaps Mr. Buffett and the computers who created them.
Somehow the genius quants — the best and brightest geeks Wall Street firms could buy — fed $1 trillion in subprime mortgage debt into their supercomputers, added some derivatives, massaged the arrangements with computer algorithms and — poof! — created $62 trillion in imaginary wealth. It’s not much of a stretch to imagine that all of that imaginary wealth is locked up somewhere inside the computers, and that we humans, led by the silverback males of the financial world, Ben Bernanke and Henry Paulson, are frantically beseeching the monolith for answers. Or maybe we are lost in space, with Dave the astronaut pleading, “Open the bank vault doors, Hal.”
As the current financial crisis spreads (like a computer virus) on the earth’s nervous system (the Internet), it’s worth asking if we have somehow managed to colossally outsmart ourselves using computers. After all, the Wall Street titans loved swaps and derivatives because they were totally unregulated by humans. That left nobody but the machines in charge.
How fitting then, that almost 30 years after Freeman Dyson described the almost unspeakable urges of the nuclear geeks creating illimitable energy out of equations, his son, George Dyson, has written an essay (published at Edge.org) warning about a different strain of technical arrogance that has brought the entire planet to the brink of financial destruction. George Dyson is an historian of technology and the author of “Darwin Among the Machines,” a book that warned us a decade ago that it was only a matter of time before technology out-evolves us and takes over.
His new essay — “Economic Dis-Equilibrium: Can You Have Your House and Spend It Too?” — begins with a history of “stock,” originally a stick of hazel, willow or alder wood, inscribed with notches indicating monetary amounts and dates. When funds were transferred, the stick was split into identical halves — with one side going to the depositor and the other to the party safeguarding the money — and represented proof positive that gold had been deposited somewhere to back it up. That was good enough for 600 years, until we decided that we needed more speed and efficiency.
Making money, it seems, is all about the velocity of moving it around, so that it can exist in Hong Kong one moment and Wall Street a split second later. “The unlimited replication of information is generally a public good,” George Dyson writes. “The problem starts, as the current crisis demonstrates, when unregulated replication is applied to money itself. Highly complex computer-generated financial instruments (known as derivatives) are being produced, not from natural factors of production or other goods, but purely from other financial instruments.”
It was easy enough for us humans to understand a stick or a dollar bill when it was backed by something tangible somewhere, but only computers can understand and derive a correlation structure from observed collateralized debt obligation tranche spreads. Which leads us to the next question: Just how much of the world’s financial stability now lies in the “hands” of computerized trading algorithms?
•
Here’s a frightening party trick that I learned from the futurist Ray Kurzweil. Read this excerpt and then I’ll tell you who wrote it:
But we are suggesting neither that the human race would voluntarily turn power over to the machines nor that the machines would willfully seize power. What we do suggest is that the human race might easily permit itself to drift into a position of such dependence on the machines that it would have no practical choice but to accept all of the machines’ decisions. ... Eventually a stage may be reached at which the decisions necessary to keep the system running will be so complex that human beings will be incapable of making them intelligently. At that stage the machines will be in effective control. People won’t be able to just turn the machines off, because they will be so dependent on them that turning them off would amount to suicide.
Brace yourself. It comes from the Unabomber’s manifesto.
Yes, Theodore Kaczinski was a homicidal psychopath and a paranoid kook, but he was also a bloodhound when it came to scenting all of the horrors technology holds in store for us. Hence his mission to kill technologists before machines commenced what he believed would be their inevitable reign of terror.
•
We are living, we have long been told, in the Information Age. Yet now we are faced with the sickening suspicion that technology has run ahead of us. Man is a fire-stealing animal, and we can’t help building machines and machine intelligences, even if, from time to time, we use them not only to outsmart ourselves but to bring us right up to the doorstep of Doom.
We are still fearful, superstitious and all-too-human creatures. At times, we forget the magnitude of the havoc we can wreak by off-loading our minds onto super-intelligent machines, that is, until they run away from us, like mad sorcerers’ apprentices, and drag us up to the precipice for a look down into the abyss.
As the financial experts all over the world use machines to unwind Gordian knots of financial arrangements so complex that only machines can make — “derive” — and trade them, we have to wonder: Are we living in a bad sci-fi movie? Is the Matrix made of credit default swaps?
When Treasury Secretary Paulson (looking very much like a frightened primate) came to Congress seeking an emergency loan, Senator Jon Tester of Montana, a Democrat still living on his family homestead, asked him: “I’m a dirt farmer. Why do we have one week to determine that $700 billion has to be appropriated or this country’s financial system goes down the pipes?”
“Well, sir,” Mr. Paulson could well have responded, “the computers have demanded it.”
Richard Dooling is the author of “Rapture for the Geeks: When A.I. Outsmarts I.Q.”
4 October 2008
Welcome back to History
"RC JOURNAL: Trend Line Assumptions
Here are some assumptions that underly all current activities related to the global financial crises:
Optimistic long term outcomes. Things are going to get better. Pollyanna mindsets.
The system, as it is currently configured, is the best possible or the only possible system. Faith in ideology.
Nation-states, singularly or collectively, are bigger and stronger than the financial/market system. The US is the guardian of this system. 20th Century legacy thinking.
The above assumptions lead to offensive (all we need to do is find the right leader) or reactive (whack a mole) mindset/policy. If you reverse them, you develop a defensive and opportunistic mindset/policy."
Here is something from your host anyways, I say that equlibrium theory and the end of history notions have doomed the self interested financial maths makers. Confused an american dollar based extra-terratorial electronic debt bubble with the permanent status quo.
I say we are on our way to a whole new chaotic attractor and that nobody has a clue as to how we get there from here.
Here are some assumptions that underly all current activities related to the global financial crises:
Optimistic long term outcomes. Things are going to get better. Pollyanna mindsets.
The system, as it is currently configured, is the best possible or the only possible system. Faith in ideology.
Nation-states, singularly or collectively, are bigger and stronger than the financial/market system. The US is the guardian of this system. 20th Century legacy thinking.
The above assumptions lead to offensive (all we need to do is find the right leader) or reactive (whack a mole) mindset/policy. If you reverse them, you develop a defensive and opportunistic mindset/policy."
Here is something from your host anyways, I say that equlibrium theory and the end of history notions have doomed the self interested financial maths makers. Confused an american dollar based extra-terratorial electronic debt bubble with the permanent status quo.
I say we are on our way to a whole new chaotic attractor and that nobody has a clue as to how we get there from here.
The Wall Street Bust:
I still owe readers a thorough analysis of the Q2 2008 Flow of Funds. For now, I’ll just point out some data relevant to the Current State of Acute Fragility.
Looking back, Total Non-Financial Debt (NFD) expanded $578bn during 1994. By 1998, NFD growth for the year had surpassed $1.0 TN. Non-Financial Credit increased $1.153 TN in 2001, $1.415 TN in 2002, and $1.676 TN in 2003, before reaching the $2.0 TN milestone in 2004. Incredible as it was, debt expansion then surged over the next fateful three years. Growth rose to $2.319 TN in 2005, $2.428 TN in 2006 and then to last year’s record $2.561 TN.
Importantly, this historic Credit Inflation inflated asset prices, incomes, corporate cashflows/earnings, government revenues, and various types of spending throughout the U.S. and global economy. It was a self-sustaining Bubble bolstered by ongoing Credit excesses, asset inflation and resulting purchasing power gains. But NFD growth slowed sharply to an annualized $1.726 TN during this year’s first quarter and then sank to $1.127 TN annualized during the second quarter. Credit growth is now in the process of collapsing.
At this point, there is clearly insufficient Credit expansion to support inflated asset markets; incomes and household spending; corporate cash flows and investment; and government receipts and expenditures. Lending markets are frozen, securitization markets broken, corporate and muni debt markets in disarray, derivatives markets in shambles, and the leveraged speculating community is engaged in panic de-leveraging. As a consequence, the over-indebted household, corporate and state & local sectors now face a devastating liquidity crisis.
We are today witnessing the Acute Stage of Bursting Credit Bubble Dynamics. It’s an absolute debacle, and there’s little our well-intentioned policymakers can do about it other then try to slow the collapse. To be sure, there were momentous effects to both the Economic and Financial Structures during the Bubble period between 1994’s $578bn Non-Financial Debt Growth and 2007’s $2.561 TN. It is also worth noting that Financial Sector Debt expanded $462bn in 1994 and $1.753 TN in 2007. Mortgage debt almost doubled in the six years 2002 through 2007 to $14.0 TN, while Financial Sector borrowings rose 75% to $16.0 TN. This Credit onslaught fostered huge distortions to the level and pattern of spending throughout the entire economy. It is today impossible both to generate sufficient Credit and to main previous patterns of spending. Economic upheaval and adjustment are today unavoidable.
Over the years I’ve chronicled this historic Bubble in Wall Street Finance. It is worth noting today that Wall Street assets began year 2000 at about $1.0 TN and ended 2007 at $3.0 TN. The ABS market surpassed $1.0 TN in 1998 and ended 2007 at $4.5 TN. GSE assets surpassed $1.0 TN in 1997 and ended last year at almost $3.4 TN. Agency MBS surpassed $2.0 TN in 1998 and closed 2007 at almost $4.5 TN. “Fed Funds and Repos” reached $1.0 TN in 2000 and ended 2007 at $2.1 TN. This Bubble in Wall Street Finance was one of history’s most spectacular Credit expansions. It also comprised the greatest use of speculative leverage ever.
Despite last summer’s collapse in private-label MBS and related markets, the Wall Street Bubble persevered up until the Lehman collapse. While it was problematic that overall system Credit growth had slowed markedly, there remained key sectors of Credit and risk intermediation that remained very much in expansionary mode. In particular, GSE-related obligations, bank Credit, and money market fund assets expanded rapidly in spite of subprime collapse. The speculators maintained easy access to cheap finance. As I have noted often, despite the unfolding bust in mortgage and risk assets, market faith in “money” had held steadfast. That ended three weeks ago with the Lehman filing.
Today, confidence has been shattered, and Wall Street finance is a complete and unsalvageable bust. The spigot for Trillions of finance - that for years fueled the asset markets and U.S. Bubble economy – has been essentially shut off. In particular, Wall Street finance was a mechanism for intermediating higher-yielding risky loans. This finance provided rocket fuel for both residential and commercial real estate markets – and the attendant wealth effects. Wall Street finance also grew into the key source of finance for auto purchases, student loans, Credit cards, municipal finance and various business enterprises. Many of these loans were of a risk profile unappealing to traditional bank lending – and, hence, provided higher yields.
And, importantly, as the stature of Wall Street finance grew its impact upon the real economy became embedded deep in the Economic Structure. Or, stated differently, risky loans came to play a major role in determining spending and investment patterns throughout the “Bubble” economy. Wall Street finance became a major direct and indirect generator of household incomes and corporate profits. Moreover, Wall Street finance came to dominate the flow of finance both in and out of the securities markets. Wall Street could create its own liquidity and funnel it into the U.S. and global markets – and earn unimaginable returns in the process.
It is today impossible to comprehend the full ramifications from The Bust in Wall Street Finance. Yet we can be rather certain that much less Credit and liquidity will be directed to the asset markets, and at the same time there will be significantly less Credit Availability for riskier loans – for the household, business, financial and the government sectors. Few appreciate that these dynamics are extremely problematic for the U.S. Bubble economy – an economy that had come to a large extent to be governed by asset-based and high-risk lending. These dynamics are at the heart of today’s imploding markets.
The leveraged speculating community played an integral role in the overall Credit Bubble and more specifically to the Bubble in Wall Street Finance. They were instrumental in both spurring financial sector Credit creation/leveraging and directing the Flow of Finance to the asset markets. And the more the leverage and the greater the Flow to inflating markets, the higher the returns generated by the speculators. And the greater the returns, the more robust the “investment” flows into the hedge fund community – and the more leverage and the more fuel for additional self-reinforcing asset inflation. Well, this historic speculative Bubble is now blowing up. One of the greatest manias ever – surely The Greatest Episode of “Ponzi Finance” – is absolutely coming apart. The wreckage is accumulating in all markets – everywhere.
Here at home, our maladjusted economic system will only be sustained by somewhere in the neighborhood of $2.0 TN of new Credit. It’s simply not going to happen. And while $700bn from Washington would seem like an enormous amount of support – in reality it’s nowhere close to the amount necessary for systemic stabilization. To the $2.0 TN or so of new Credit required add perhaps as much as several Trillion more necessary to accommodate speculative de-leveraging. The Bust in Wall Street Finance has ensured that insufficient liquidity will be forthcoming to maintain inflated asset prices and sustain the Bubble economy – creating catastrophe for the leveraged speculating community.
The “Freidmanites” thought they understood the policy mistakes that led to The Great Depression. They believed the “Roaring Twenties” was the “Golden Age of Capitalism.” The great bust could have been avoided with a simple ($5bn) banking system recapitalization. As we are witnessing today, the issue is not a manageable amount of new “capital” to replenish banking system losses, but instead the massive and unmanageable amount of new Credit necessary to, on the one hand, sustain a mal-adjusted Bubble Economy and, on the other, accommodate a gigantic speculative de-leveraging. I have a very difficult time seeing a way out of this terrible mess.
Looking back, Total Non-Financial Debt (NFD) expanded $578bn during 1994. By 1998, NFD growth for the year had surpassed $1.0 TN. Non-Financial Credit increased $1.153 TN in 2001, $1.415 TN in 2002, and $1.676 TN in 2003, before reaching the $2.0 TN milestone in 2004. Incredible as it was, debt expansion then surged over the next fateful three years. Growth rose to $2.319 TN in 2005, $2.428 TN in 2006 and then to last year’s record $2.561 TN.
Importantly, this historic Credit Inflation inflated asset prices, incomes, corporate cashflows/earnings, government revenues, and various types of spending throughout the U.S. and global economy. It was a self-sustaining Bubble bolstered by ongoing Credit excesses, asset inflation and resulting purchasing power gains. But NFD growth slowed sharply to an annualized $1.726 TN during this year’s first quarter and then sank to $1.127 TN annualized during the second quarter. Credit growth is now in the process of collapsing.
At this point, there is clearly insufficient Credit expansion to support inflated asset markets; incomes and household spending; corporate cash flows and investment; and government receipts and expenditures. Lending markets are frozen, securitization markets broken, corporate and muni debt markets in disarray, derivatives markets in shambles, and the leveraged speculating community is engaged in panic de-leveraging. As a consequence, the over-indebted household, corporate and state & local sectors now face a devastating liquidity crisis.
We are today witnessing the Acute Stage of Bursting Credit Bubble Dynamics. It’s an absolute debacle, and there’s little our well-intentioned policymakers can do about it other then try to slow the collapse. To be sure, there were momentous effects to both the Economic and Financial Structures during the Bubble period between 1994’s $578bn Non-Financial Debt Growth and 2007’s $2.561 TN. It is also worth noting that Financial Sector Debt expanded $462bn in 1994 and $1.753 TN in 2007. Mortgage debt almost doubled in the six years 2002 through 2007 to $14.0 TN, while Financial Sector borrowings rose 75% to $16.0 TN. This Credit onslaught fostered huge distortions to the level and pattern of spending throughout the entire economy. It is today impossible both to generate sufficient Credit and to main previous patterns of spending. Economic upheaval and adjustment are today unavoidable.
Over the years I’ve chronicled this historic Bubble in Wall Street Finance. It is worth noting today that Wall Street assets began year 2000 at about $1.0 TN and ended 2007 at $3.0 TN. The ABS market surpassed $1.0 TN in 1998 and ended 2007 at $4.5 TN. GSE assets surpassed $1.0 TN in 1997 and ended last year at almost $3.4 TN. Agency MBS surpassed $2.0 TN in 1998 and closed 2007 at almost $4.5 TN. “Fed Funds and Repos” reached $1.0 TN in 2000 and ended 2007 at $2.1 TN. This Bubble in Wall Street Finance was one of history’s most spectacular Credit expansions. It also comprised the greatest use of speculative leverage ever.
Despite last summer’s collapse in private-label MBS and related markets, the Wall Street Bubble persevered up until the Lehman collapse. While it was problematic that overall system Credit growth had slowed markedly, there remained key sectors of Credit and risk intermediation that remained very much in expansionary mode. In particular, GSE-related obligations, bank Credit, and money market fund assets expanded rapidly in spite of subprime collapse. The speculators maintained easy access to cheap finance. As I have noted often, despite the unfolding bust in mortgage and risk assets, market faith in “money” had held steadfast. That ended three weeks ago with the Lehman filing.
Today, confidence has been shattered, and Wall Street finance is a complete and unsalvageable bust. The spigot for Trillions of finance - that for years fueled the asset markets and U.S. Bubble economy – has been essentially shut off. In particular, Wall Street finance was a mechanism for intermediating higher-yielding risky loans. This finance provided rocket fuel for both residential and commercial real estate markets – and the attendant wealth effects. Wall Street finance also grew into the key source of finance for auto purchases, student loans, Credit cards, municipal finance and various business enterprises. Many of these loans were of a risk profile unappealing to traditional bank lending – and, hence, provided higher yields.
And, importantly, as the stature of Wall Street finance grew its impact upon the real economy became embedded deep in the Economic Structure. Or, stated differently, risky loans came to play a major role in determining spending and investment patterns throughout the “Bubble” economy. Wall Street finance became a major direct and indirect generator of household incomes and corporate profits. Moreover, Wall Street finance came to dominate the flow of finance both in and out of the securities markets. Wall Street could create its own liquidity and funnel it into the U.S. and global markets – and earn unimaginable returns in the process.
It is today impossible to comprehend the full ramifications from The Bust in Wall Street Finance. Yet we can be rather certain that much less Credit and liquidity will be directed to the asset markets, and at the same time there will be significantly less Credit Availability for riskier loans – for the household, business, financial and the government sectors. Few appreciate that these dynamics are extremely problematic for the U.S. Bubble economy – an economy that had come to a large extent to be governed by asset-based and high-risk lending. These dynamics are at the heart of today’s imploding markets.
The leveraged speculating community played an integral role in the overall Credit Bubble and more specifically to the Bubble in Wall Street Finance. They were instrumental in both spurring financial sector Credit creation/leveraging and directing the Flow of Finance to the asset markets. And the more the leverage and the greater the Flow to inflating markets, the higher the returns generated by the speculators. And the greater the returns, the more robust the “investment” flows into the hedge fund community – and the more leverage and the more fuel for additional self-reinforcing asset inflation. Well, this historic speculative Bubble is now blowing up. One of the greatest manias ever – surely The Greatest Episode of “Ponzi Finance” – is absolutely coming apart. The wreckage is accumulating in all markets – everywhere.
Here at home, our maladjusted economic system will only be sustained by somewhere in the neighborhood of $2.0 TN of new Credit. It’s simply not going to happen. And while $700bn from Washington would seem like an enormous amount of support – in reality it’s nowhere close to the amount necessary for systemic stabilization. To the $2.0 TN or so of new Credit required add perhaps as much as several Trillion more necessary to accommodate speculative de-leveraging. The Bust in Wall Street Finance has ensured that insufficient liquidity will be forthcoming to maintain inflated asset prices and sustain the Bubble economy – creating catastrophe for the leveraged speculating community.
The “Freidmanites” thought they understood the policy mistakes that led to The Great Depression. They believed the “Roaring Twenties” was the “Golden Age of Capitalism.” The great bust could have been avoided with a simple ($5bn) banking system recapitalization. As we are witnessing today, the issue is not a manageable amount of new “capital” to replenish banking system losses, but instead the massive and unmanageable amount of new Credit necessary to, on the one hand, sustain a mal-adjusted Bubble Economy and, on the other, accommodate a gigantic speculative de-leveraging. I have a very difficult time seeing a way out of this terrible mess.
2 October 2008
36 Hours of Alarm and Action as Crisis Spiraled
By JOE NOCERA
Published: October 1, 2008
This article was reported by Andrew Ross Sorkin, Diana B. Henriques, Edmund L. Andrews and Joe Nocera. It was written by Mr. Nocera.
“Panic can cause a prudent person to do rational things that can contribute to the failure of an institution.” — William A. Ackman of the hedge fund Pershing Square Capital Management.
It was early on Wednesday, Sept. 17, when executives at Pershing Square, Bill Ackman's hedge fund, began getting nervous calls and e-mail messages from investors. Mr. Ackman, 42, has been a top Wall Street player for 15 years, making his clients — and himself — billions of dollars.
But now, Mr. Ackman and his colleagues were taken aback by what they were hearing. His big investors were worried about all of the Pershing assets held by Goldman Sachs, the blue-chip investment bank, whose stock had come under siege.
Never mind that Goldman kept Pershing's assets in a segregated account, and that the money was safe. And never mind that Mr. Ackman believed Goldman was the world's best-run investment bank and would come through the credit crisis unscathed.
Pershing investors still feared their money might be exposed. Mr. Ackman advised Goldman executives to do something to restore confidence — such as getting an infusion of capital from Warren E. Buffett, the billionaire investor. And while Mr. Ackman kept his assets at Goldman, he hurriedly set up accounts at three other institutions — just in case things got much worse.
Pershing had more faith than most. Up and down Wall Street, hedge funds with billions of dollars at Goldman and Morgan Stanley, another storied investment bank, were frantically pulling money out and looking for safer havens.
Panic was spreading on two of the scariest days ever in financial markets, and the biggest investors — not small investors — were panicking the most. Nobody was sure how much damage it would cause before it ended.
This is what a credit crisis looks like. It's not like a stock market crisis, where the scary plunge of stocks is obvious to all. The credit crisis has played out in places most people can't see. It's banks refusing to lend to other banks — even though that is one of the most essential functions of the banking system. It's a loss of confidence in seemingly healthy institutions like Morgan Stanley and Goldman — both of which reported profits even as the pressure was mounting. It is panicked hedge funds pulling out cash. It is frightened investors protecting themselves by buying credit-default swaps — a financial insurance policy against potential bankruptcy — at prices 30 times what they normally would pay.
It was this 36-hour period two weeks ago — from the morning of Wednesday, Sept. 17, to the afternoon of Thursday, Sept. 18 — that spooked policy makers by opening fissures in the worldwide financial system.
In their rush to do something, and do it fast, the Federal Reserve chairman, Ben S. Bernanke, and Treasury Secretary Henry M. Paulson Jr. concluded the time had come to use the “break the glass” rescue plan they had been developing. But in their urgency, they bypassed a crucial step in Washington and fashioned their $700 billion bailout without political spadework, which led to a resounding rejection this past Monday in the House of Representatives.
That Thursday evening, however, time was of the essence. In a hastily convened meeting in the conference room of the House speaker, Nancy Pelosi, the two men presented, in the starkest terms imaginable, the outline of the $700 billion plan to Congressional leaders. “If we don't do this,” Mr. Bernanke said, according to several participants, “we may not have an economy on Monday.”
Setting the Stage
Wall Street executives and federal officials had known since the previous weekend that it was likely to be a difficult week.
With the government refusing to offer the same financial guarantees that helped save Bear Stearns, Fannie Mae and Freddie Mac, efforts on Saturday to find a buyer for Lehman Brothers had failed.
Sunday was spent preparing to deal with Lehman's bankruptcy, which was announced Monday morning. Merrill Lynch, fearing it would be next, had agreed to be bought by Bank of America. The American International Group was near collapse. (It would be rescued with an $85 billion loan from the Federal Reserve on Tuesday evening.)
With government policy makers appearing to careen from crisis to crisis, the Dow Jones industrial average plunged 504 points on Monday. Panic was in the air.
At those weekend meetings, Wall Street executives and federal officials talked about the possibility of contagion — that the Lehman bankruptcy might set off so much fear among investors that the market “would pivot to the next weakest firm in the herd,” as one federal official put it.
That firm, everyone knew, was likely to be Morgan Stanley, whose stock had been dropping since the previous Monday, Sept. 8. Within three hours on Tuesday, Sept. 16, Morgan Stanley shares fell another 28 percent, and the rising cost of its credit-default swaps suggested investors were predicting bankruptcy.
To allay the panic, the firm decided to report earnings a day early — after the market closed Tuesday afternoon instead of Wednesday morning. The profit was terrific — $1.425 billion, just a 3 percent decline from 2007 — and the thinking was that would give investors the night to absorb the good news.
“I am hoping that this will generally help calm the market,” Morgan Stanley's chief financial officer, Colm A. Kelleher, said in an interview late that afternoon. “These markets are behaving irrationally. There's a lot of fear.”
The Spreading Contagion
But contagion was already spreading. The problem posed by the Lehman bankruptcy was not the losses suffered by hedge funds and other investors who traded stocks or bonds with the firms. As federal officials had predicted, that turned out to be manageable. (That was one reason the government did not step in to save the firm.)
The real problem was that a handful of hedge funds that used the firm's London office to handle their trades had billions of dollars in balances frozen in the bankruptcy.
Diamondback Capital Management, for instance, a $3 billion hedge fund, told its investors that 14.9 percent of its assets were locked up in the Lehman bankruptcy — money it could not extract. A number of other hedge funds were in the same predicament. (When called for comment, Diamondback officials did not answer the phone.)
As this news spread, every other hedge fund manager had to worry about whether the balances they had at other Wall Street firms might suffer a similar fate. And Morgan Stanley and Goldman Sachs were the two biggest firms left that served this back-office role. That is why Mr. Ackman's investors were calling him. And that is what caused hedge funds to pull money out of Morgan Stanley and Goldman Sachs, hedge their exposure by buying credit-default swaps that would cover losses if either firm couldn't pay money they owed — or do both.
It was fear, not greed, that was driving everyone's actions.
Breaking the Buck
There was another piece of bad news spooking investors — and government officials. On Tuesday, the Reserve Primary Fund, a $64 billion money market fund, and two smaller, related funds, revealed that they had “broken the buck” and would pay investors no more than 97 cents on the dollar.
Money market funds serve a critical role in greasing the wheels of commerce. They use investors' money to make short-term loans, known as commercial paper, to big corporations like General Motors, I.B.M. and Microsoft. Commercial paper is attractive to money market funds because it pays them a higher interest rate than, say, United States Treasury bills, but is still considered relatively safe.
A run on money funds could force fund managers to shy away from commercial paper, fearing the loans were no longer safe. One reason given by the Reserve Primary Fund for breaking the buck was that it had bought Lehman commercial paper with a face value of $785 million that was now worth little because of its bankruptcy. If money market funds became fearful of buying commercial paper, that would make it far more difficult for companies to raise the cash needed to pay employees, for instance. At that point, it would not just be the credit markets that were frozen, but commerce itself.
Just as important, in the eyes of federal officials, was that money market funds had long been viewed by investors as akin to bank accounts — a safe place to store cash and earn interest on that money. Despite lacking federal deposit insurance, these funds held $3.4 trillion in assets.
“Breaking the buck was the Rubicon,” said a federal official. “This was the first time in the crisis that you could see stories talking about how it was affecting real people.”
Since that Monday, big institutional investors — like pension funds and college endowments — had been pulling money out of money funds. On Tuesday, individual investors joined the stampede.
At the Investment Company Institute, the trade group for the mutual fund industry, executives had organized a conference call that week with top-level fund executives and government officials.
“We were saying to Treasury and the Fed, at a very high level: Pay attention to this issue. This will have an impact,” recalled Greg Ahern, the group's chief communication officer.
But government officials monitoring the crisis did not need the warning. They were already watching money fund outflows with alarm.
Surprisingly, stock investors — feeling better because of the government's A.I.G. rescue plan — either did not comprehend or ignored the growing chaos in credit markets; the Dow actually rose 141.51 points on Tuesday.
A Dark Day
The respite was brief. Wednesday, Sept. 17, was one of those dark, ugly market days that offers not even a glimmer of hope.
Fearing the worst, Alex Ehrlich, the global head of prime services at the Swiss bank UBS, arrived at work in New York at 5 a.m. and immediately started putting out fires. Because he ran the firm's prime brokerage unit, clients were calling to see whether their money was safe.
“We were being flooded with client requests to move positions, and the funding markets, which are critically important to prime brokers, were extremely volatile,” he said.
Within seconds of the market opening, the Dow was down 160 points. Among the big losers was Morgan Stanley. Despite the strong earnings it had disclosed late Tuesday, its stock continued to plummet. By noon, the Dow was down 330 points. It rallied in the afternoon, but went into free fall in the last 45 minutes, closing down 449 points.
And that was just what investors could see. Behind the scenes, the credit markets had almost completely frozen up. Banks were refusing to lend to other banks, and spreads on credit default swaps on financial stocks — the price of insuring against bankruptcy — veered into uncharted waters.
Moreover, the drain on money funds continued. By the end of business on Wednesday, institutional investors had withdrawn more than $290 billion from money market funds. In what experts call a “flight to safety,” investors were taking money out of stocks and bonds and even money market funds and buying the safest investments in the world: Treasury bills. As a result, yields on short-term Treasury bills dropped close to zero. That was almost unheard of.
In the stock market, Mr. Ehrlich of UBS was horrified by the plunge of Morgan Stanley's shares, given the stellar earnings. “It felt like there was no ground beneath your feet,” he said. “I didn't know where it was going to end.”
A Chief Executive's Anger
Neither did Morgan Stanley's chief executive, John J. Mack. A week before, his firm's stock was trading in the mid-40s. On Wednesday, it fell from $28.70 a share to $21.75 — down about 50 percent over a week.
“There is no rational basis for the movements in our stock or credit default spreads,” Mr. Mack wrote in a companywide memo on Wednesday. Mr. Mack lashed out at the people he felt were responsible for Morgan Stanley's woes: the short-sellers, who profit by betting that a stock will fall.
Like most Wall Street firms, Morgan Stanley over the years had handled transactions for short-sellers, despite complaints by other companies that short-sellers unfairly ganged up on their stock. Nevertheless, Mr. Mack called Senator Charles E. Schumer, Democrat of New York, and Christopher Cox, the chairman of the Securities and Exchange Commission, pressing them to ban short-selling.
He raged about what he viewed as a concerted effort to drive down the firm's stock. “He got emotional,” says one person who knows him well.
Meeting with staff members Thursday morning as the stock plunged further — hitting a low of $11.70 midday — Mr. Mack said: “Listen. I know everybody is anxious about the stock price. I'm not selling any shares, and neither is my team. But I understand if you're nervous and want to sell some shares.” Some did. (The company said fewer than one-third of employees sold stock that day.)
At the same time, Mr. Mack began talks to merge with Wachovia, and called other banks about possible combinations. He also called Mr. Buffett for advice, while aides in Tokyo contacted Mitsubishi UFJ, Japan's biggest lender, hoping to raise additional capital.
Run on a Fund
Even as stocks tanked, turmoil was worsening in money markets. On Wednesday evening, Paul Schott Stevens, the head of the Investment Company Institute, learned about a problem with another money fund. “This time it was Putnam,” recalled Mr. Stevens, referring to the Boston-based mutual fund company Putnam Investments.
Out of the blue, it seemed, there was a run on the $12.3 billion Putnam Prime Money Market Fund. That meant the money fund contagion was spreading. Because of huge withdrawals, Putnam decided it had to shut the fund, and distribute the cash to shareholders. If it did not, the first ones out the door would get a better deal than the laggards.
Executives of the Investment Company Institute and fund officials scrambled to find a solution that would keep Putnam from having to take that step, but they failed. On Thursday, Putnam shuttered the fund. (After the government rescue plan was announced, it sold the fund, intact, to another company, and investors did not lose a penny.)
The Fed Takes Action
Ben Bernanke had spent his career studying financial crises. His first important work as an economist had been a study of the events that led to the Great Depression. Along with several economists, he came up with a phrase, “the financial accelerator,” which described how deteriorating market conditions could speed until they became unmanageable.
To an alarming degree, the credit crisis had played out as his academic work predicted. But his research also led Mr. Bernanke to the view that “situations where crises have really spiraled out of control are where the central bank has been on the sideline,” according to Mark Gertler, a New York University economist who has collaborated with Mr. Bernanke on some papers.
Mr. Bernanke had no intention of keeping the Fed on the sidelines. As the crisis deepened, it took more aggressive steps. It added liquidity to the system. It opened the discount window — the emergency lending facility that had been reserved for troubled banks — to investment banks. It also agreed to absorb up to $29 billion in Bear Stearns losses and made an $85 billion loan to keep A.I.G. afloat.
Representative Barney Frank, the Massachusetts Democrat who leads the House Financial Services Committee, asked Mr. Bernanke if the Fed had $85 billion to spare. “We have $800 billion,” Mr. Bernanke replied, according to Mr. Frank.
Since the Bear Stearns bailout, Treasury and Fed officials had discussed what a broad government intervention might look like. Although there were suggestions for a “bank holiday” — a temporary, nationwide closing of banks, which had not been done since 1933, to stem panicky withdrawals — Mr. Bernanke and Mr. Paulson dismissed the idea, fearing it would do far more harm than good by scaring people needlessly. They had both assembled teams to map out drastic rescue plans — the “break the glass” plans.
Almost from the start, they concluded the best systemic solution was to buy hard-to-sell mortgage-backed securities.
On Wednesday morning, during a conference call with other top officials, including Jean-Claude Trichet, the president of the European Central Bank, Mr. Bernanke sounded them out on a big government bailout. The other officials sounded relieved; their main questions were about whether Congress could act quickly.
That evening, Mr. Bernanke told Mr. Paulson during a conference call: “You have to go to Congress. This is pervasive.” Mr. Paulson agreed.
A Sense of Urgency
By Thursday morning, the need for dramatic action had grown even more urgent.
In Asia, stocks had already closed lower. To quell fears before the opening of European markets, the Fed and other central banks announced they would make $180 billion available, in an effort to get banks to start lending to each other again. The Fed had agreed to open its discount window to make loans available to money market funds to prevent further runs.
But it was to little avail.
At 8:30 Thursday morning in the United States, when Mr. Paulson and Mr. Bernanke reviewed the state of affairs, markets remained roiled. The crisis was not easing up.
One Bank's Solution
Lloyd C. Blankfein, Goldman Sachs's chief executive, had arrived at the firm's office on 85 Broad Street just before 7 a.m. Thursday, anticipating another bad day. The investment bank's stock had already been pummeled. From nearly $250 a share last October, it had fallen to $114.50 on Wednesday — after hitting a low of $97.78 that day.
One idea he had been exploring was to transform Goldman into a bank holding company. Mr. Mack, meantime, was also considering such a move for Morgan Stanley, and both were in separate discussions with the Fed. There was safety in that notion — they would become depository institutions regulated by the Fed and others — though it also meant they would not be able to pile on as much debt as they had as investment banks. That would hurt profits. But now profits were less pressing than survival. Mr. Blankfein accelerated the planning.
By 1 p.m., the Dow had fallen another 150 points — meaning that in a day and a half it was down nearly 600 points. Goldman's stock dropped to $85.88, its lowest in nearly six years.
Just then, a prankster piped “The Star-Spangled Banner” over the firm's loudspeaker system on the 50th floor. Fixed-income traders stopped and stood at attention, some with hands on their hearts. Oddly, it was at precisely that moment that the market — and Goldman's shares — started to rise.
The traders began to cheer.
Curbing Short-Selling
What happened? At 1 p.m. New York time, the Financial Services Authority in Britain, which regulates that nation's financial institutions, announced a ban on short-selling of 29 financial stocks that would last at least 30 days.
“When I saw that, I knew we were about to have the mother of all short squeezes,” said one hedge fund manager. Realizing that the S.E.C. was likely to follow suit, hedge funds began “covering their shorts” — that is, buying the stocks they had borrowed to short, even if it meant taking a loss.
That caused all kinds of stocks to begin rising. Sure enough, the S.E.C. followed suit the next day, placing a temporary short-selling ban on 799 financial stocks.
A few hours later came the second event. At 3:01 CNBC reported the Treasury and the Fed were planning a giant fund to buy toxic mortgage-backed assets from financial institutions. Though there had been hints of this earlier in the afternoon, and stocks had started rising around 2:30, the wide dissemination set off a huge rally. In a 45-minute burst, the Dow gained another 300 points, closing the day up 410 points.
Meeting on Capitol Hill
Two hours later, Mr. Paulson and Mr. Bernanke trooped up to Capitol Hill for a somber session with Congressional leaders. “That meeting was one of the most astounding experiences I've had in my 34 years in politics,” Senator Schumer recalled.
As the members of Congress and their aides listened, the two laid out their plan. They would begin offering federal insurance to money market funds immediately, in order to stop the run on money funds.
In addition, the S.E.C. would institute a ban on short-selling of financial stocks. Although Treasury officials concede that the move was mostly symbolic — investors can still buy put options that have the same effect as shorting stocks — they did it mainly “to scare the hell out of everybody,” as one official put it.
After Mr. Bernanke made his remark about the possibility that there might not be an economy on Monday without this plan, you could hear a pin drop.
“I gulped,” Mr. Schumer said.
Congressional leaders were nearly unanimous in saying that it needed to be done for the good of the country. Representative John A. Boehner of Ohio — the Republican House leader who a week later would lead the revolt against the plan — said it was time to put politics aside and move quickly, according to several participants. (An aide to Mr. Boehner denied that he voiced support for the plan, only that he made a plea for cooperation.)
Hearing that Mr. Bernanke and Mr. Paulson wanted legislation passed in a matter of days, the Senate majority leader, Harry Reid, expressed astonishment. “This is the United States Senate,” he said. “We can't do it in that time frame.” His Republican counterpart, Senator Mitch McConnell, replied, “This time we can.”
He was wrong. After a week of wrangling, political infighting and compromise, the House on Monday voted down the legislation. The Dow plunged nearly 778 points, and credit markets had worsened, with interest rates rising and loans becoming harder to obtain.
Two weeks after Mr. Paulson and Mr. Bernanke made their appeal, the House is likely to try again.
Additional reporting was by Jenny Anderson, Nelson D. Schwartz, Eric Dash, Louise Story, Michael M. Grynbaum, Carter Dougherty and Vikas Bajaj.
Published: October 1, 2008
This article was reported by Andrew Ross Sorkin, Diana B. Henriques, Edmund L. Andrews and Joe Nocera. It was written by Mr. Nocera.
“Panic can cause a prudent person to do rational things that can contribute to the failure of an institution.” — William A. Ackman of the hedge fund Pershing Square Capital Management.
It was early on Wednesday, Sept. 17, when executives at Pershing Square, Bill Ackman's hedge fund, began getting nervous calls and e-mail messages from investors. Mr. Ackman, 42, has been a top Wall Street player for 15 years, making his clients — and himself — billions of dollars.
But now, Mr. Ackman and his colleagues were taken aback by what they were hearing. His big investors were worried about all of the Pershing assets held by Goldman Sachs, the blue-chip investment bank, whose stock had come under siege.
Never mind that Goldman kept Pershing's assets in a segregated account, and that the money was safe. And never mind that Mr. Ackman believed Goldman was the world's best-run investment bank and would come through the credit crisis unscathed.
Pershing investors still feared their money might be exposed. Mr. Ackman advised Goldman executives to do something to restore confidence — such as getting an infusion of capital from Warren E. Buffett, the billionaire investor. And while Mr. Ackman kept his assets at Goldman, he hurriedly set up accounts at three other institutions — just in case things got much worse.
Pershing had more faith than most. Up and down Wall Street, hedge funds with billions of dollars at Goldman and Morgan Stanley, another storied investment bank, were frantically pulling money out and looking for safer havens.
Panic was spreading on two of the scariest days ever in financial markets, and the biggest investors — not small investors — were panicking the most. Nobody was sure how much damage it would cause before it ended.
This is what a credit crisis looks like. It's not like a stock market crisis, where the scary plunge of stocks is obvious to all. The credit crisis has played out in places most people can't see. It's banks refusing to lend to other banks — even though that is one of the most essential functions of the banking system. It's a loss of confidence in seemingly healthy institutions like Morgan Stanley and Goldman — both of which reported profits even as the pressure was mounting. It is panicked hedge funds pulling out cash. It is frightened investors protecting themselves by buying credit-default swaps — a financial insurance policy against potential bankruptcy — at prices 30 times what they normally would pay.
It was this 36-hour period two weeks ago — from the morning of Wednesday, Sept. 17, to the afternoon of Thursday, Sept. 18 — that spooked policy makers by opening fissures in the worldwide financial system.
In their rush to do something, and do it fast, the Federal Reserve chairman, Ben S. Bernanke, and Treasury Secretary Henry M. Paulson Jr. concluded the time had come to use the “break the glass” rescue plan they had been developing. But in their urgency, they bypassed a crucial step in Washington and fashioned their $700 billion bailout without political spadework, which led to a resounding rejection this past Monday in the House of Representatives.
That Thursday evening, however, time was of the essence. In a hastily convened meeting in the conference room of the House speaker, Nancy Pelosi, the two men presented, in the starkest terms imaginable, the outline of the $700 billion plan to Congressional leaders. “If we don't do this,” Mr. Bernanke said, according to several participants, “we may not have an economy on Monday.”
Setting the Stage
Wall Street executives and federal officials had known since the previous weekend that it was likely to be a difficult week.
With the government refusing to offer the same financial guarantees that helped save Bear Stearns, Fannie Mae and Freddie Mac, efforts on Saturday to find a buyer for Lehman Brothers had failed.
Sunday was spent preparing to deal with Lehman's bankruptcy, which was announced Monday morning. Merrill Lynch, fearing it would be next, had agreed to be bought by Bank of America. The American International Group was near collapse. (It would be rescued with an $85 billion loan from the Federal Reserve on Tuesday evening.)
With government policy makers appearing to careen from crisis to crisis, the Dow Jones industrial average plunged 504 points on Monday. Panic was in the air.
At those weekend meetings, Wall Street executives and federal officials talked about the possibility of contagion — that the Lehman bankruptcy might set off so much fear among investors that the market “would pivot to the next weakest firm in the herd,” as one federal official put it.
That firm, everyone knew, was likely to be Morgan Stanley, whose stock had been dropping since the previous Monday, Sept. 8. Within three hours on Tuesday, Sept. 16, Morgan Stanley shares fell another 28 percent, and the rising cost of its credit-default swaps suggested investors were predicting bankruptcy.
To allay the panic, the firm decided to report earnings a day early — after the market closed Tuesday afternoon instead of Wednesday morning. The profit was terrific — $1.425 billion, just a 3 percent decline from 2007 — and the thinking was that would give investors the night to absorb the good news.
“I am hoping that this will generally help calm the market,” Morgan Stanley's chief financial officer, Colm A. Kelleher, said in an interview late that afternoon. “These markets are behaving irrationally. There's a lot of fear.”
The Spreading Contagion
But contagion was already spreading. The problem posed by the Lehman bankruptcy was not the losses suffered by hedge funds and other investors who traded stocks or bonds with the firms. As federal officials had predicted, that turned out to be manageable. (That was one reason the government did not step in to save the firm.)
The real problem was that a handful of hedge funds that used the firm's London office to handle their trades had billions of dollars in balances frozen in the bankruptcy.
Diamondback Capital Management, for instance, a $3 billion hedge fund, told its investors that 14.9 percent of its assets were locked up in the Lehman bankruptcy — money it could not extract. A number of other hedge funds were in the same predicament. (When called for comment, Diamondback officials did not answer the phone.)
As this news spread, every other hedge fund manager had to worry about whether the balances they had at other Wall Street firms might suffer a similar fate. And Morgan Stanley and Goldman Sachs were the two biggest firms left that served this back-office role. That is why Mr. Ackman's investors were calling him. And that is what caused hedge funds to pull money out of Morgan Stanley and Goldman Sachs, hedge their exposure by buying credit-default swaps that would cover losses if either firm couldn't pay money they owed — or do both.
It was fear, not greed, that was driving everyone's actions.
Breaking the Buck
There was another piece of bad news spooking investors — and government officials. On Tuesday, the Reserve Primary Fund, a $64 billion money market fund, and two smaller, related funds, revealed that they had “broken the buck” and would pay investors no more than 97 cents on the dollar.
Money market funds serve a critical role in greasing the wheels of commerce. They use investors' money to make short-term loans, known as commercial paper, to big corporations like General Motors, I.B.M. and Microsoft. Commercial paper is attractive to money market funds because it pays them a higher interest rate than, say, United States Treasury bills, but is still considered relatively safe.
A run on money funds could force fund managers to shy away from commercial paper, fearing the loans were no longer safe. One reason given by the Reserve Primary Fund for breaking the buck was that it had bought Lehman commercial paper with a face value of $785 million that was now worth little because of its bankruptcy. If money market funds became fearful of buying commercial paper, that would make it far more difficult for companies to raise the cash needed to pay employees, for instance. At that point, it would not just be the credit markets that were frozen, but commerce itself.
Just as important, in the eyes of federal officials, was that money market funds had long been viewed by investors as akin to bank accounts — a safe place to store cash and earn interest on that money. Despite lacking federal deposit insurance, these funds held $3.4 trillion in assets.
“Breaking the buck was the Rubicon,” said a federal official. “This was the first time in the crisis that you could see stories talking about how it was affecting real people.”
Since that Monday, big institutional investors — like pension funds and college endowments — had been pulling money out of money funds. On Tuesday, individual investors joined the stampede.
At the Investment Company Institute, the trade group for the mutual fund industry, executives had organized a conference call that week with top-level fund executives and government officials.
“We were saying to Treasury and the Fed, at a very high level: Pay attention to this issue. This will have an impact,” recalled Greg Ahern, the group's chief communication officer.
But government officials monitoring the crisis did not need the warning. They were already watching money fund outflows with alarm.
Surprisingly, stock investors — feeling better because of the government's A.I.G. rescue plan — either did not comprehend or ignored the growing chaos in credit markets; the Dow actually rose 141.51 points on Tuesday.
A Dark Day
The respite was brief. Wednesday, Sept. 17, was one of those dark, ugly market days that offers not even a glimmer of hope.
Fearing the worst, Alex Ehrlich, the global head of prime services at the Swiss bank UBS, arrived at work in New York at 5 a.m. and immediately started putting out fires. Because he ran the firm's prime brokerage unit, clients were calling to see whether their money was safe.
“We were being flooded with client requests to move positions, and the funding markets, which are critically important to prime brokers, were extremely volatile,” he said.
Within seconds of the market opening, the Dow was down 160 points. Among the big losers was Morgan Stanley. Despite the strong earnings it had disclosed late Tuesday, its stock continued to plummet. By noon, the Dow was down 330 points. It rallied in the afternoon, but went into free fall in the last 45 minutes, closing down 449 points.
And that was just what investors could see. Behind the scenes, the credit markets had almost completely frozen up. Banks were refusing to lend to other banks, and spreads on credit default swaps on financial stocks — the price of insuring against bankruptcy — veered into uncharted waters.
Moreover, the drain on money funds continued. By the end of business on Wednesday, institutional investors had withdrawn more than $290 billion from money market funds. In what experts call a “flight to safety,” investors were taking money out of stocks and bonds and even money market funds and buying the safest investments in the world: Treasury bills. As a result, yields on short-term Treasury bills dropped close to zero. That was almost unheard of.
In the stock market, Mr. Ehrlich of UBS was horrified by the plunge of Morgan Stanley's shares, given the stellar earnings. “It felt like there was no ground beneath your feet,” he said. “I didn't know where it was going to end.”
A Chief Executive's Anger
Neither did Morgan Stanley's chief executive, John J. Mack. A week before, his firm's stock was trading in the mid-40s. On Wednesday, it fell from $28.70 a share to $21.75 — down about 50 percent over a week.
“There is no rational basis for the movements in our stock or credit default spreads,” Mr. Mack wrote in a companywide memo on Wednesday. Mr. Mack lashed out at the people he felt were responsible for Morgan Stanley's woes: the short-sellers, who profit by betting that a stock will fall.
Like most Wall Street firms, Morgan Stanley over the years had handled transactions for short-sellers, despite complaints by other companies that short-sellers unfairly ganged up on their stock. Nevertheless, Mr. Mack called Senator Charles E. Schumer, Democrat of New York, and Christopher Cox, the chairman of the Securities and Exchange Commission, pressing them to ban short-selling.
He raged about what he viewed as a concerted effort to drive down the firm's stock. “He got emotional,” says one person who knows him well.
Meeting with staff members Thursday morning as the stock plunged further — hitting a low of $11.70 midday — Mr. Mack said: “Listen. I know everybody is anxious about the stock price. I'm not selling any shares, and neither is my team. But I understand if you're nervous and want to sell some shares.” Some did. (The company said fewer than one-third of employees sold stock that day.)
At the same time, Mr. Mack began talks to merge with Wachovia, and called other banks about possible combinations. He also called Mr. Buffett for advice, while aides in Tokyo contacted Mitsubishi UFJ, Japan's biggest lender, hoping to raise additional capital.
Run on a Fund
Even as stocks tanked, turmoil was worsening in money markets. On Wednesday evening, Paul Schott Stevens, the head of the Investment Company Institute, learned about a problem with another money fund. “This time it was Putnam,” recalled Mr. Stevens, referring to the Boston-based mutual fund company Putnam Investments.
Out of the blue, it seemed, there was a run on the $12.3 billion Putnam Prime Money Market Fund. That meant the money fund contagion was spreading. Because of huge withdrawals, Putnam decided it had to shut the fund, and distribute the cash to shareholders. If it did not, the first ones out the door would get a better deal than the laggards.
Executives of the Investment Company Institute and fund officials scrambled to find a solution that would keep Putnam from having to take that step, but they failed. On Thursday, Putnam shuttered the fund. (After the government rescue plan was announced, it sold the fund, intact, to another company, and investors did not lose a penny.)
The Fed Takes Action
Ben Bernanke had spent his career studying financial crises. His first important work as an economist had been a study of the events that led to the Great Depression. Along with several economists, he came up with a phrase, “the financial accelerator,” which described how deteriorating market conditions could speed until they became unmanageable.
To an alarming degree, the credit crisis had played out as his academic work predicted. But his research also led Mr. Bernanke to the view that “situations where crises have really spiraled out of control are where the central bank has been on the sideline,” according to Mark Gertler, a New York University economist who has collaborated with Mr. Bernanke on some papers.
Mr. Bernanke had no intention of keeping the Fed on the sidelines. As the crisis deepened, it took more aggressive steps. It added liquidity to the system. It opened the discount window — the emergency lending facility that had been reserved for troubled banks — to investment banks. It also agreed to absorb up to $29 billion in Bear Stearns losses and made an $85 billion loan to keep A.I.G. afloat.
Representative Barney Frank, the Massachusetts Democrat who leads the House Financial Services Committee, asked Mr. Bernanke if the Fed had $85 billion to spare. “We have $800 billion,” Mr. Bernanke replied, according to Mr. Frank.
Since the Bear Stearns bailout, Treasury and Fed officials had discussed what a broad government intervention might look like. Although there were suggestions for a “bank holiday” — a temporary, nationwide closing of banks, which had not been done since 1933, to stem panicky withdrawals — Mr. Bernanke and Mr. Paulson dismissed the idea, fearing it would do far more harm than good by scaring people needlessly. They had both assembled teams to map out drastic rescue plans — the “break the glass” plans.
Almost from the start, they concluded the best systemic solution was to buy hard-to-sell mortgage-backed securities.
On Wednesday morning, during a conference call with other top officials, including Jean-Claude Trichet, the president of the European Central Bank, Mr. Bernanke sounded them out on a big government bailout. The other officials sounded relieved; their main questions were about whether Congress could act quickly.
That evening, Mr. Bernanke told Mr. Paulson during a conference call: “You have to go to Congress. This is pervasive.” Mr. Paulson agreed.
A Sense of Urgency
By Thursday morning, the need for dramatic action had grown even more urgent.
In Asia, stocks had already closed lower. To quell fears before the opening of European markets, the Fed and other central banks announced they would make $180 billion available, in an effort to get banks to start lending to each other again. The Fed had agreed to open its discount window to make loans available to money market funds to prevent further runs.
But it was to little avail.
At 8:30 Thursday morning in the United States, when Mr. Paulson and Mr. Bernanke reviewed the state of affairs, markets remained roiled. The crisis was not easing up.
One Bank's Solution
Lloyd C. Blankfein, Goldman Sachs's chief executive, had arrived at the firm's office on 85 Broad Street just before 7 a.m. Thursday, anticipating another bad day. The investment bank's stock had already been pummeled. From nearly $250 a share last October, it had fallen to $114.50 on Wednesday — after hitting a low of $97.78 that day.
One idea he had been exploring was to transform Goldman into a bank holding company. Mr. Mack, meantime, was also considering such a move for Morgan Stanley, and both were in separate discussions with the Fed. There was safety in that notion — they would become depository institutions regulated by the Fed and others — though it also meant they would not be able to pile on as much debt as they had as investment banks. That would hurt profits. But now profits were less pressing than survival. Mr. Blankfein accelerated the planning.
By 1 p.m., the Dow had fallen another 150 points — meaning that in a day and a half it was down nearly 600 points. Goldman's stock dropped to $85.88, its lowest in nearly six years.
Just then, a prankster piped “The Star-Spangled Banner” over the firm's loudspeaker system on the 50th floor. Fixed-income traders stopped and stood at attention, some with hands on their hearts. Oddly, it was at precisely that moment that the market — and Goldman's shares — started to rise.
The traders began to cheer.
Curbing Short-Selling
What happened? At 1 p.m. New York time, the Financial Services Authority in Britain, which regulates that nation's financial institutions, announced a ban on short-selling of 29 financial stocks that would last at least 30 days.
“When I saw that, I knew we were about to have the mother of all short squeezes,” said one hedge fund manager. Realizing that the S.E.C. was likely to follow suit, hedge funds began “covering their shorts” — that is, buying the stocks they had borrowed to short, even if it meant taking a loss.
That caused all kinds of stocks to begin rising. Sure enough, the S.E.C. followed suit the next day, placing a temporary short-selling ban on 799 financial stocks.
A few hours later came the second event. At 3:01 CNBC reported the Treasury and the Fed were planning a giant fund to buy toxic mortgage-backed assets from financial institutions. Though there had been hints of this earlier in the afternoon, and stocks had started rising around 2:30, the wide dissemination set off a huge rally. In a 45-minute burst, the Dow gained another 300 points, closing the day up 410 points.
Meeting on Capitol Hill
Two hours later, Mr. Paulson and Mr. Bernanke trooped up to Capitol Hill for a somber session with Congressional leaders. “That meeting was one of the most astounding experiences I've had in my 34 years in politics,” Senator Schumer recalled.
As the members of Congress and their aides listened, the two laid out their plan. They would begin offering federal insurance to money market funds immediately, in order to stop the run on money funds.
In addition, the S.E.C. would institute a ban on short-selling of financial stocks. Although Treasury officials concede that the move was mostly symbolic — investors can still buy put options that have the same effect as shorting stocks — they did it mainly “to scare the hell out of everybody,” as one official put it.
After Mr. Bernanke made his remark about the possibility that there might not be an economy on Monday without this plan, you could hear a pin drop.
“I gulped,” Mr. Schumer said.
Congressional leaders were nearly unanimous in saying that it needed to be done for the good of the country. Representative John A. Boehner of Ohio — the Republican House leader who a week later would lead the revolt against the plan — said it was time to put politics aside and move quickly, according to several participants. (An aide to Mr. Boehner denied that he voiced support for the plan, only that he made a plea for cooperation.)
Hearing that Mr. Bernanke and Mr. Paulson wanted legislation passed in a matter of days, the Senate majority leader, Harry Reid, expressed astonishment. “This is the United States Senate,” he said. “We can't do it in that time frame.” His Republican counterpart, Senator Mitch McConnell, replied, “This time we can.”
He was wrong. After a week of wrangling, political infighting and compromise, the House on Monday voted down the legislation. The Dow plunged nearly 778 points, and credit markets had worsened, with interest rates rising and loans becoming harder to obtain.
Two weeks after Mr. Paulson and Mr. Bernanke made their appeal, the House is likely to try again.
Additional reporting was by Jenny Anderson, Nelson D. Schwartz, Eric Dash, Louise Story, Michael M. Grynbaum, Carter Dougherty and Vikas Bajaj.
1 October 2008
100-Year Events - Now Happening Every Day
Who knows, but once the present has turned into history today's rejection of US Treasury Secretary Hank Paulson's $700 billion bailout package by Congress may be seen as the final straw that broke the back of international capital markets.
100-year events are becoming common fare these days and central banks have no other idea than to turn the spigots wide open. In a concerted action the central banks of the USA, Canada, the UK, Denmark, Norway, the Eurozone, Switzerland, Australia, Japan and Sweden expanded their FRN swap lines from $290 billion to a whopping $620 billion, the Federal Reserve announced on Monday morning.
This came after the financial crisis made further inroads into Europe.
Over the weekend ECB president Jean-Claude Trichet hammered out an agreement that Belgium, Luxemburg and the Netherlands would partially nationalize Fortis Bank and injected roughly €10 billion in order to save the bank as a going concern.
German taxpayers will remember September 29 for getting milked to the tune of €26 billion as their share in a €35 billion bailout package for lender Hypo Real Estate.
In the UK taxpayers will pick up the bill for the nationalization of Bradford & Bingley.
In the USA, Citigroup's throat got stuffed with Wachovia.
And all this happens in a matter of hours only.
Bank shares in Europe (and then later in the US) tumbled across the board as conscience gains ground that Europe will not be spared by the ongoing desintegration of the US financial system.
Wall Street's descent by some 6% was only topped by the Vienna stock exchange, where plunging real estate and bank shares led the ATX to a close more than 8% below Friday's levels. This was the second biggest plunge in the history of Austria. Austrian shares have begun to fall out of favor with investors because of their exposure to suddenly ailing East European economies which were the primary profit driver in this decade.
ECB Stays on Inflationary Course
The European Central Bank appears to try to avoid another bank failure by running its printing presses even hotter. On Monday the ECB announced more basically unlimited special refinancing operations in order to keep bids close to the official rates. This comes only 3 days after the ECB had announced more FRN repos - which were topped up again today.
As a general note I would say that central banks act like headless chickens since a year. With their boundless monetary creation at warp speed that is running into the trillions by now central banks will only be able to delay the oncoming European financial Tsunami, but the inevitable - a massive deflation of asset prices - will happen anyway.
Wall Street's deep dive today will echo around the world tomorrow. Expect Asian and European markets to open markedly lower.
In times of a true crisis gold again proved its safe haven status. In contrast to all other commodities (crude oil fell 10%) the oldest currency of the world shot up to $920 after the US congress rejected the bailout package. It may not take very long and we will see huge advances of gold once the financial wizards discover its unchallenged role as a store of value in times when all other paper assets see dramatic markdowns.
100-year events are becoming common fare these days and central banks have no other idea than to turn the spigots wide open. In a concerted action the central banks of the USA, Canada, the UK, Denmark, Norway, the Eurozone, Switzerland, Australia, Japan and Sweden expanded their FRN swap lines from $290 billion to a whopping $620 billion, the Federal Reserve announced on Monday morning.
This came after the financial crisis made further inroads into Europe.
Over the weekend ECB president Jean-Claude Trichet hammered out an agreement that Belgium, Luxemburg and the Netherlands would partially nationalize Fortis Bank and injected roughly €10 billion in order to save the bank as a going concern.
German taxpayers will remember September 29 for getting milked to the tune of €26 billion as their share in a €35 billion bailout package for lender Hypo Real Estate.
In the UK taxpayers will pick up the bill for the nationalization of Bradford & Bingley.
In the USA, Citigroup's throat got stuffed with Wachovia.
And all this happens in a matter of hours only.
Bank shares in Europe (and then later in the US) tumbled across the board as conscience gains ground that Europe will not be spared by the ongoing desintegration of the US financial system.
Wall Street's descent by some 6% was only topped by the Vienna stock exchange, where plunging real estate and bank shares led the ATX to a close more than 8% below Friday's levels. This was the second biggest plunge in the history of Austria. Austrian shares have begun to fall out of favor with investors because of their exposure to suddenly ailing East European economies which were the primary profit driver in this decade.
ECB Stays on Inflationary Course
The European Central Bank appears to try to avoid another bank failure by running its printing presses even hotter. On Monday the ECB announced more basically unlimited special refinancing operations in order to keep bids close to the official rates. This comes only 3 days after the ECB had announced more FRN repos - which were topped up again today.
As a general note I would say that central banks act like headless chickens since a year. With their boundless monetary creation at warp speed that is running into the trillions by now central banks will only be able to delay the oncoming European financial Tsunami, but the inevitable - a massive deflation of asset prices - will happen anyway.
Wall Street's deep dive today will echo around the world tomorrow. Expect Asian and European markets to open markedly lower.
In times of a true crisis gold again proved its safe haven status. In contrast to all other commodities (crude oil fell 10%) the oldest currency of the world shot up to $920 after the US congress rejected the bailout package. It may not take very long and we will see huge advances of gold once the financial wizards discover its unchallenged role as a store of value in times when all other paper assets see dramatic markdowns.
30 September 2008
Why US banks are failing
The reason why the banks are going bust in simple terms is:
The banks traded in complex derivatives products between themselves, in what is termed as the over the counter market. The exposure to the Securitized debt packages was further exaggerated by the use of leverage of in many cases more than 30X the banks assets against valuations based on complex models that inflated the packages values during the boom times which allowed huge profits and bonuses to be banked (Fraud?). However the critical point is in the final link in a long chain of sliced and diced debt packages was the US housing market.
As US house prices fell, the gap between the real value and the banks inflated model values to boost profits grew, until the crunch point of August 2007, when it dawned upon market participants that in actual fact they did not have a clue as to the real value of these mortgage backed securities and hence the credit markets froze as no one wanted to buy something they could not value and nor lend to financial institutions that may default on their obligations. The impact hit all banks, whether or not they had exposure to the US housing market, as those banks whose business model relied heavily on the short-term money markets to finance long-term mortgages were in deep trouble, i.e. Northern Rock and to a lesser extent ALL of the other UK mortgage banks.
Now many banks are left with assets that are worth LESS than 50% of their "mark to market" booked value. Now that does not mean a 50% loss for the banks on investments, remember the greedy banks deployed LEVERAGE of as much as 30 times of assets, so capital of say £100 million is controlling risk of as much as £3,000 million. Therefore a 50% loss results in a loss of value of £1,500 million, that's 15 TIMES the capital. Hence the banks have been reluctant to price their debt packages at the real market price as that would mean that the bank is effectively bankrupt with losses far greater than the banks capital base. So the market remains frozen until all of the illiquid mortgage backed debt has been transferred over to the tax payers in exchange for liquid cash, hence prompting the US Mother of All bailouts plan.
So Basically there are TWO related problems at work driving the Banks Bust:
1. One of collatorised debt that is not being valued at market prices, hence frozen money markets with banks sitting on over leveraged time bombs that have started to explode in recent weeks, as the credit markets tighten further.
2. Mortgage banks reliant on short-term money markets to finance long-term mortgages that threw caution to the wind and loaned far too much money to people who could not afford to repay the mortgages are now being hit by increasing defaults as the western housing markets crash from over inflated 'bubble' levels, as their losses mushroom but now find that they are unable to borrow money to cover day to day operations due to the increased risk of default and thus hoarding of cash (if they have any left) amongst investment banks in advance of further asset price mark downs. Therefore the only avenue available for short-term cash is from either the Bank of England or individual savers, hence high savings interest rates relative to the base interest rate of 5%.
And there's more .... mortgage backed securities are the tip of the credit crunch iceberg, the next inline are credit default swaps which are basically investor insurance to protect themselves against losses on the debt packages. However as we saw with collapse of and nationalisation of the worlds biggest insurer AIG, this is another huge part of the derivatives market that is imploding, perhaps in the region of $60 trillion. Its the reason why ordinary people are going to find problems with the credit card freeze next as defaults rise and retailers start to charge a premium on card transaction due to risk of default on the transactions, or even refuse to accept credit cards, but that has yet to happen..
United States Answer To Collapsing Banks is a $700 Billion Bailout Plan
Despite all of the noise of Congress's qualms that we will witness played out during the next 24 hours or so, the bailout plan will more or less pass . Despite the fact that it represents madness, an ultimate manifestation of the subprime contaigent spreading and infecting the US Treasury with all of the consequences of loss of confidence in ALL US paper as the value of US debt devalues in the eyes of all investors.
The US Treasury and Central Bank are eager to get the US Congress to pass a blank check bill so as much of the toxic mortgage backed bonds can be bought up to prevent a further collapse of the financial system. $700 billion is not enough, not in the face of the huge deleveraging of the $500 trillion dollar market, as I warned of 6 months ago. The $700 bailout plans two un-said objectives are -
a. To delay the potential of financial collapse until AFTER the November election.
b. That the real bailout cost will run to several trillion dollars as the US government seeks to prevent a chain reaction of collapsing banks in the wake of counter party failures amongst the huge $500 trillion global derivatives market.
The latest tactics is to suggest that the US Tax payer may even make a profit on these toxic securities. The fact of the matter is that the US will probably be looking at a loss of over 50% on maturity of the anticipated price paid as there is no way that market prices will be paid, as primary reason for the freeze of the interbank money markets is that the securities are NOT being priced by the market for if they were then the market valuations would imply that the financial institutions are bankrupt, hence the free market has been suspended. Taking an estimated eventual exposure of some $2 trillions, therefore implies an eventual US tax payer loss of at least $1 trillion. Which is more than enough to send the US bond market toppling as the US is heading for a budget deficit of more than $1 trillion.
The real question that the peoples representatives should be focusing themselves on is how do we bring those who benefited from the greatest fraud in history to account for their actions and the possible repatriation of wealth stolen in recent years to the tune of more than $1 trillion due to huge bonuses paid on the back of boosted fake asset valuations. That would probably increase confidence in US paper more than signing a blank check for $700 billion .
Is your Bank Safe ?
The US Fed's and other central back actions do not mean that banks will now be saved, as last weeks example of WaMu going bust, America's biggest bank failure illustrates that literally many hundreds if not a thousand plus banks will go bust during the course of the worsening credit crisis, with all of the consequences for depositors. The following report by EWI presents a list of the 100 safest US banks.
UK Toxic State Mortgage Bank
The ground work for the bank bailouts was laid earlier in March and April 08 on the announcements that the UK Government would loan £50 billion to the Banks in exchange for toxic illiquid mortgage backed securities in an attempt to unfreeze the interbank market , at the time I warned that this is just the first step and that eventual liability would extend to several hundred billions if pounds which would still be a drop in the ocean compared to the ongoing deleveraging of a 500 trillion derivatives market which has highly deflationary implications for the credit and asset markets as we have been observing in recent weeks.
First Northern Rock and now Bradford and Bingley mark Britain's own emergency government intervention of the bailout of toxic mortgage backed securities. The estimated UK tax payer exposure in terms of anticipated losses to date is about £40 billion, £20 billion for Northern Rock and £20 billion for B&B. This is in addition to the money loaned to the UK banks as a consequence of the freeze of the interbank money markets and represents a total tax payer exposure to of at least £150 billion, or some $280 billion which compares against the US tax payer exposure of approximately $1.2 trillion that takes into account the proposed $700 billion weekend bailout.
What can Savers do ?
The only thing that savers can do is to attempt to limit real terms losses as much as possible, this implies locking in fixed savings rates ahead of now increasingly anticipated interest rate cuts. The first port of call should be fixed rate cash ISA's which currently range between 6% and 7.3%. The next port of call should be Fixed rate bonds for at least 1year and preferably 2 years, in this case savers have a window of opportunity with rates ranging from between 6.3% to as high as 7.2%. The current market leader is ICICI Bank which pays 7.2% for terms of between 1 and 3 years. Remember to adhere to the limits mentioned above of £35k per banking group.
UK Housing Market
The implications for the UK housing market both as a consequence of the HBOS takeover and Bradford and Bingley bust are going to hit the mortgage market hard with both a reduction in supply of mortgages and an eagerness of the two banks to seek to reduce their mortgage books by trying to induce their customers to remortgage to other banks via higher mortgage interest rates and therefore reduce their risks of default in the wake of the ongoing housing bear market.
The Labour government has attempted to support the housing market by suspending the 1% stamp duty taxed on house purchases on properties up to a value of £175,000 for a period of 1 year and to support new house prices through Homebuy Direct Interest Free loans.
The Halifax's latest house price data shows that the housing market crash continued to accelerate into August, plunging by 1.7% that saw another £3000 wiped off house prices following the £3,300 write off for July to stand at down 12.8% on the year to August (on a non seasonally adjusted basis). UK house prices have now fallen by more than 8% since April. If a fall of 8% in 4 months cannot be considered a crash in UK house prices than I do not know what can. No wonder Chancellor Darling virtually threw in the towel recently in his famous "I give up, please let me spend more time with my family" speech.
The banks traded in complex derivatives products between themselves, in what is termed as the over the counter market. The exposure to the Securitized debt packages was further exaggerated by the use of leverage of in many cases more than 30X the banks assets against valuations based on complex models that inflated the packages values during the boom times which allowed huge profits and bonuses to be banked (Fraud?). However the critical point is in the final link in a long chain of sliced and diced debt packages was the US housing market.
As US house prices fell, the gap between the real value and the banks inflated model values to boost profits grew, until the crunch point of August 2007, when it dawned upon market participants that in actual fact they did not have a clue as to the real value of these mortgage backed securities and hence the credit markets froze as no one wanted to buy something they could not value and nor lend to financial institutions that may default on their obligations. The impact hit all banks, whether or not they had exposure to the US housing market, as those banks whose business model relied heavily on the short-term money markets to finance long-term mortgages were in deep trouble, i.e. Northern Rock and to a lesser extent ALL of the other UK mortgage banks.
Now many banks are left with assets that are worth LESS than 50% of their "mark to market" booked value. Now that does not mean a 50% loss for the banks on investments, remember the greedy banks deployed LEVERAGE of as much as 30 times of assets, so capital of say £100 million is controlling risk of as much as £3,000 million. Therefore a 50% loss results in a loss of value of £1,500 million, that's 15 TIMES the capital. Hence the banks have been reluctant to price their debt packages at the real market price as that would mean that the bank is effectively bankrupt with losses far greater than the banks capital base. So the market remains frozen until all of the illiquid mortgage backed debt has been transferred over to the tax payers in exchange for liquid cash, hence prompting the US Mother of All bailouts plan.
So Basically there are TWO related problems at work driving the Banks Bust:
1. One of collatorised debt that is not being valued at market prices, hence frozen money markets with banks sitting on over leveraged time bombs that have started to explode in recent weeks, as the credit markets tighten further.
2. Mortgage banks reliant on short-term money markets to finance long-term mortgages that threw caution to the wind and loaned far too much money to people who could not afford to repay the mortgages are now being hit by increasing defaults as the western housing markets crash from over inflated 'bubble' levels, as their losses mushroom but now find that they are unable to borrow money to cover day to day operations due to the increased risk of default and thus hoarding of cash (if they have any left) amongst investment banks in advance of further asset price mark downs. Therefore the only avenue available for short-term cash is from either the Bank of England or individual savers, hence high savings interest rates relative to the base interest rate of 5%.
And there's more .... mortgage backed securities are the tip of the credit crunch iceberg, the next inline are credit default swaps which are basically investor insurance to protect themselves against losses on the debt packages. However as we saw with collapse of and nationalisation of the worlds biggest insurer AIG, this is another huge part of the derivatives market that is imploding, perhaps in the region of $60 trillion. Its the reason why ordinary people are going to find problems with the credit card freeze next as defaults rise and retailers start to charge a premium on card transaction due to risk of default on the transactions, or even refuse to accept credit cards, but that has yet to happen..
United States Answer To Collapsing Banks is a $700 Billion Bailout Plan
Despite all of the noise of Congress's qualms that we will witness played out during the next 24 hours or so, the bailout plan will more or less pass . Despite the fact that it represents madness, an ultimate manifestation of the subprime contaigent spreading and infecting the US Treasury with all of the consequences of loss of confidence in ALL US paper as the value of US debt devalues in the eyes of all investors.
The US Treasury and Central Bank are eager to get the US Congress to pass a blank check bill so as much of the toxic mortgage backed bonds can be bought up to prevent a further collapse of the financial system. $700 billion is not enough, not in the face of the huge deleveraging of the $500 trillion dollar market, as I warned of 6 months ago. The $700 bailout plans two un-said objectives are -
a. To delay the potential of financial collapse until AFTER the November election.
b. That the real bailout cost will run to several trillion dollars as the US government seeks to prevent a chain reaction of collapsing banks in the wake of counter party failures amongst the huge $500 trillion global derivatives market.
The latest tactics is to suggest that the US Tax payer may even make a profit on these toxic securities. The fact of the matter is that the US will probably be looking at a loss of over 50% on maturity of the anticipated price paid as there is no way that market prices will be paid, as primary reason for the freeze of the interbank money markets is that the securities are NOT being priced by the market for if they were then the market valuations would imply that the financial institutions are bankrupt, hence the free market has been suspended. Taking an estimated eventual exposure of some $2 trillions, therefore implies an eventual US tax payer loss of at least $1 trillion. Which is more than enough to send the US bond market toppling as the US is heading for a budget deficit of more than $1 trillion.
The real question that the peoples representatives should be focusing themselves on is how do we bring those who benefited from the greatest fraud in history to account for their actions and the possible repatriation of wealth stolen in recent years to the tune of more than $1 trillion due to huge bonuses paid on the back of boosted fake asset valuations. That would probably increase confidence in US paper more than signing a blank check for $700 billion .
Is your Bank Safe ?
The US Fed's and other central back actions do not mean that banks will now be saved, as last weeks example of WaMu going bust, America's biggest bank failure illustrates that literally many hundreds if not a thousand plus banks will go bust during the course of the worsening credit crisis, with all of the consequences for depositors. The following report by EWI presents a list of the 100 safest US banks.
UK Toxic State Mortgage Bank
The ground work for the bank bailouts was laid earlier in March and April 08 on the announcements that the UK Government would loan £50 billion to the Banks in exchange for toxic illiquid mortgage backed securities in an attempt to unfreeze the interbank market , at the time I warned that this is just the first step and that eventual liability would extend to several hundred billions if pounds which would still be a drop in the ocean compared to the ongoing deleveraging of a 500 trillion derivatives market which has highly deflationary implications for the credit and asset markets as we have been observing in recent weeks.
First Northern Rock and now Bradford and Bingley mark Britain's own emergency government intervention of the bailout of toxic mortgage backed securities. The estimated UK tax payer exposure in terms of anticipated losses to date is about £40 billion, £20 billion for Northern Rock and £20 billion for B&B. This is in addition to the money loaned to the UK banks as a consequence of the freeze of the interbank money markets and represents a total tax payer exposure to of at least £150 billion, or some $280 billion which compares against the US tax payer exposure of approximately $1.2 trillion that takes into account the proposed $700 billion weekend bailout.
What can Savers do ?
The only thing that savers can do is to attempt to limit real terms losses as much as possible, this implies locking in fixed savings rates ahead of now increasingly anticipated interest rate cuts. The first port of call should be fixed rate cash ISA's which currently range between 6% and 7.3%. The next port of call should be Fixed rate bonds for at least 1year and preferably 2 years, in this case savers have a window of opportunity with rates ranging from between 6.3% to as high as 7.2%. The current market leader is ICICI Bank which pays 7.2% for terms of between 1 and 3 years. Remember to adhere to the limits mentioned above of £35k per banking group.
UK Housing Market
The implications for the UK housing market both as a consequence of the HBOS takeover and Bradford and Bingley bust are going to hit the mortgage market hard with both a reduction in supply of mortgages and an eagerness of the two banks to seek to reduce their mortgage books by trying to induce their customers to remortgage to other banks via higher mortgage interest rates and therefore reduce their risks of default in the wake of the ongoing housing bear market.
The Labour government has attempted to support the housing market by suspending the 1% stamp duty taxed on house purchases on properties up to a value of £175,000 for a period of 1 year and to support new house prices through Homebuy Direct Interest Free loans.
The Halifax's latest house price data shows that the housing market crash continued to accelerate into August, plunging by 1.7% that saw another £3000 wiped off house prices following the £3,300 write off for July to stand at down 12.8% on the year to August (on a non seasonally adjusted basis). UK house prices have now fallen by more than 8% since April. If a fall of 8% in 4 months cannot be considered a crash in UK house prices than I do not know what can. No wonder Chancellor Darling virtually threw in the towel recently in his famous "I give up, please let me spend more time with my family" speech.
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