Monday, December 01, 2008

Best Explanation of the Crisis We Face

While I know DailyKos has become somewhat of a progressive bogeyman among the partisan right, not entirely unreasonably, some of its editors (authorized regular columnists) have extraordinary credentials who I find worth the read despite the partisan orientation. Frankly, the real polemics can be found in the largely unregulated "Diaries" posted by registered users in the right column. That can take a lot of sifting to find quality content.

That aside, on a technical basis both in accuracy and writing skill, this is the best post I've seen yet explaining the current state of the crisis that has been unfolding over a year now. It's critical to understand that what started as a "subprime mortgage" crisis last year has now expanded to reveal certain "shadow" financial instruments that Warren Buffett himself famously called "Financial Weapons of Mass Destruction" in a 2002 memo to his shareholders. The post I'm highlighting was written by a blogger named "Devilstower," however don't be fooled: this is no teenager proverbially blogging from his mother's basement in his pajamas.

In his November 16th post, the author reviews the biggest threat to our financial system currently, and that's the fallout over the failure of the "Credit Default Swap," a derivative that is essentially unregulated "insurance" at best, and worse, outright "gambling with no bookie." From his intro:

In essence, credit default swaps are (or were) nothing but insurance policies for loans. And yet in 2007 the total number of credit default swaps traded far exceeded the value of all loans. In fact, it may have touched $70 trillion dollars, which puts it above the gross domestic product of the entire planet.

Yes, $70 TRILLION. That doesn't mean the money exists, it just represents the value of all the "bets" outstanding. It's easy to see now what Buffett was talking about way back in 2002 when the government, regulators, and certainly investors had no clue what these things were really about.

If a person goes bankrupt and cannot pay back a loan, and the person insuring the loan for the lender cannot pay the insurance payout that was obligated, then the lender must bear the entire cost of the loan failure. In turn, the lender either a) cannot lend more money because of the loss it must now cover, or b) the lender may also be an insurer on another failed loan to another institution and now itself cannot pay out. This is over-simplified, but it's easy to see how multiple failures like this set off an extraordinarily dangerous chain reaction of radioactive proportions. That is what the nation is dealing with in large part right now.

I do not believe that now is not the time to begin diagnosing how we got into this mess. If we wait until we are out of this mess, history shows we are far less likely to bother with an accurate diagnosis that could lead to effective future protections. 2008 Nobel winner Krugman:

Why did almost everyone believe in the omnipotence of the Federal Reserve when its counterpart, the Bank of Japan, spent a decade trying and failing to jump-start a stalled economy?

One answer ... is that nobody likes a party pooper. While the housing bubble was still inflating, lenders[, investment banks, and money managers] were making lots of money... Who wanted to hear from dismal economists warning that the whole thing was, in effect, a giant Ponzi scheme?

There’s also another reason the economic policy establishment failed to see the current crisis coming. ... [T]he crisis of 1997-98... showed that the modern financial system, with its deregulated markets, highly leveraged players and global capital flows, was becoming dangerously fragile. But when the crisis abated, the order of the day was triumphalism, not soul-searching.

Time magazine famously named Mr. Greenspan, Robert Rubin and Lawrence Summers “The Committee to Save the World”... who “prevented a global meltdown.” In effect, everyone declared ... victory..., while forgetting to ask how we got so close to the brink in the first place.
So now, following is Devilstower's very important point to build on Krugman: the current crisis can largely be traced back to a piece of legislation passed in 2000 and signed into law by President Clinton with bipartisan support, clearly before anyone except a few really understood what they were doing:

In 2000 Republican economic hero, Phil Gramm, with the assistance of a small legion of lobbyists [and Democrats], created the Commodity Futures Modernization Act [signed into law by then President Clinton]. Along with ushering in the Enron disaster, this bill provided the one thing that credit default swaps needed to grow and mutate -- invisibility. Thanks to the CFMA, not only were credit default swaps unregulated, they were impossible to observe directly. Like black holes in deep space, you could only spot swaps by looking at how other things acted nearby.

So, now you've made a loan to someone, and you're worried about it. I want to offer you a credit default swap so I can collect the fee. Trouble is, I don't have the assets to cover your loan. So how can I... hold on, credit default swaps are so unregulated that no one says I actually have to be able to deliver on my promise. Hey, over here! Have I got a swap for you, and it's a bargain.

So now the CDS is a means of moving the risk, but the risk is still as high (or higher, since the original lender might have been better able to cover the loss). In fact, credit default swaps have gone from being a risk mitigator, to a risk magnifier.
A risk magnifier indeed. And most of this, along with most of the activity of private hedge funds (extraordinarily aggressive investment funds using massive amounts of loans with very little cash reserves), went completely unregulated and unmonitored. So a big part of the current problem is that nobody can really figure out just how much of this stuff is really out there in the market and in what form.

Contrast this with the heavy regulation, for the public and investor good, required of public securities overseen by the SEC and also required of insurance products. The regulatory requirements for these classic instruments are legion, but they are designed to increase the availability and accuracy of information in the marketplace so that both investors and regulators can make the most informed decisions about their market choices.

It should go without saying that $70 trillion in undisclosed "positions" (bets) in the marketplace is not immaterial to the decisions that investors and regulators were making in the last 8 years before this crisis. But congress, through the 2000 CFMA, let all of this go under the radar, unregistered, unregulated.

Here's the crux of how things went so wrong and got so out of control. Again from Devilstower:

Swaps are unregulated. No one says I have to have enough resources to cover the swap, and even better, no one says I have to offer the swap to the person who actually made the loan! Hey buddy, see that loan over there? You may think it's iffy, but I think it'll hold up. In fact, I'm so sure it will, I'll sell you a credit default swap on it that pays off if it fails. You don't make the loan, you don't have to pay off on the loan, you don't have anything to do with the loan. You just pay me the fee. And if that guy loses his money, you collect. How sweet is that!

This mutation is enormous(...) At this point, credit default swaps [became] completely divorced from the original function. A single loan can be covered by multiple swaps. There's a complicated fiscal term for this. It's called gambling, and at this stage, that's all that remains of those little "insurance" policies. They no longer protect anyone from anything, they just offer a chance to place enormous overlapping side bets on everything.
So there it is. An instrument sold to congressional accomplices on both sides of the aisle and an unknowing, unsuspecting market as a "risk mitigator" actually mushroomed in a cloud of unregulated, invisible massive $70 TRILLION side bets with no bookie.

Financial weapons of mass destruction indeed.