[FoRK] Pol/Econ: The Insolvency Crisis: How we got here, and what to expect

Eugen Leitl <eugen at leitl.org> on Sun Aug 12 10:22:45 PDT 2007

(check out the original page for graphs and images)


Pol/Econ: The Insolvency Crisis: How we got here, and what to expect
Saturday, 11 August 2007 Written by Garrett Johnson

    “For these ten marks I sold my virtue.”

	- written on the back of German banknote, 1923

The news of the Federal Reserve injecting $38 billion into the
mortgage-backed securities market didn't get a lot of attention yesterday,
but it should have.

    Since a third injection is unprecedented, as such infusions typically
only occur during a crisis, investors are again left wondering just how bad
the subprime situation is and questioning whether or not an emergency rate
cut would even be enough to avert a possible true credit crunch.

It was the largest infusion by the Fed since the 9/11 aftermath. But it paled
in comparison to the European Central Bank's two day infusion of 155 Billion

What does it all mean? To answer that we must dig deeper than the headlines
and take a look back in time.

Irony is a dish best served cold

In late 1997 the hedge fund Long Term Capital Management was Wall Street
royalty. With not one, but two Nobel Prize winners in economics on staff,
they consistently generated 40%+ returns for their investors. Their
mathematical models seemed to have conquered all the mysteries of high

Then they lost $4.8 Billion in 1998 and nearly became insolvent.

On September 21, 1998, the Federal Reserve called 16 major Wall Street
investment banks together for an unprecedented meeting to bail out the hedge
fund that they had all lent money to. The reason was because LTCM had
leveraged their portfolio to $1 Trillion, and there was a real fear that the
bond market would seize up as creditors rushed to the exits. Some of that was
already happening. 11 of those banks signed off on the bailout. The Federal
Reserve pushed billion of dollars of liquidity into the markets - almost
exactly the same as what the Fed did yesterday. Bear Stearns refused to

Fast forward nine years. Three hedge funds run by Bear Stearns become
insolvent. Bear Stearns has the nerve to ask its other investment banks, many
of them part of the LTCM bailout in 1998, for its own bailout. Instead, they
seize the assets of those hedge funds, and Bear Stearns is force to use $3.2
Billion of its own reserves to cover its losses.

But the irony doesn't end there. Yesterday Goldman Sachs, a participating
member of the LTCM bailout team, announced their largest hedge fund lost 15%
of its capital over the last month. It seems the Alpha Fund was using
complicated mathematical models similar to what LTCM used.

Meanwhile, Merrill Lynch tried to sell the assets that they seized from Bear
Stearns but failed because they couldn't even get 11 cents on the dollar for
those mortgage-backed bonds.

Some are now predicting that half of the hedge funds on Wall Street will go
bust in the next five years. At the same time, the debt markets have seized

What happened? How could the brainiacs on Wall Street make the same stupid
mistakes less than a decade later?

To answer that, let's look at what happened during those nine years and how
Wall Street works.

How we got here

    Moral Hazard: refers to the possibility that the redistribution of risk
(such as insurance which transfers risk from the insured to the insurer)
changes people's behaviour.

The bailout of LTCM convinced many that there was a "too big to fail"
condition that companies can meet where the Federal Reserve would always ride
to the rescue. Meanwhile a financial instrument evolved from obscurity to
being the dominant feature in the world of finance - asset-backed securities.
These became important as the Fed dropped interest rates from 6% to 1% in
2001 and 2002, causing a " tidal wave of money moving into the bank deposit
base". All that liquidity (a fancy name for "credit") needed to get loaned
out in order to make profits on it, and the already booming real estate
market (because of artificially low interest rates) was the perfect target.

Once those loans were made the banks could then bundle up a collection of
mortgages into an ABS and sell it to the secondary mortgage market,
traditionally a pension fund or insurance company. But with the exploding
trade deficit, foreign nations were looking to recycle their surplus dollars
back into American markets. Buying those mortgage-backed securities became a
leading method of doing that.

When Fannie Mae and Freddie Mac got into an $11.3 Billion accounting scandal
in 2004 (it took them five years before they actually filed again on time
with the SEC), the burden of funding the real estate bubble fell to the ABS
market. $2 Trillion in mortgages were created this way.

The moral hazard of this arose from the fact that the people selling the
mortgages didn't have to worry about ever getting paid back because someone
else was buying those mortgages and taking on the risk. What's more, foreign
investors were unlikely of being fully aware of who was getting these loans.
Credit standards dropped to ridiculous levels. Migrant farm workers were
qualifying for $250K, no-down, interest-only mortgages. Money was being made
by the boatloads. Speculators swarmed the business. Homeowners began
extracting the equity from their homes even faster than their home values
could rise, and using the money to buy expensive toys. In other words, using
their homes as ATM machines.

It was a disaster waiting to happen.

Where we are now

A large percentage of those new mortgages were 2/28's - a low, two-year
"teaser" interest rate, which then resets to a much higher market rate. As
those mortgages reset, foreclosure rates spiked.

    "Normal foreclosure rate in the United States is anywhere from 300,000 to
500,000 per year. Now the projected rate is 1.7 million," said Jessica
Cecere, president of Consumer Credit Counseling Service.

Mortgage resets (in billions)

Foreclosures as of May, 2007

Of course, where the foreclosures have been so far isn't necessarily where
the foreclosures will be in the near future (think "west").

Even insiders say that the real estate market won't bottom for another year.

Federal Reserve Chairman Ben S. Bernanke and U.S. Treasury Secretary Henry
Paulson assured us that the subprime mess was "contained" and wouldn't spill
out onto the general market. They lied.

    "The subprime mess is now spreading to banks," says Nariman Behravesh,
chief economist at Global Insight Inc. in Lexington, Massachusetts. "A lot of
international banks, especially those in Europe, did invest a lot in the
collateralized debt markets, especially the subprime situation here in the
U.S., so they're suffering."

116 mortgage lenders have imploded since 2006. 11 hedge funds have imploded
in just the last couple months. So have two european banks.

A rumor says that interbank lending completely shut down for several hours
this week. Borrowing costs have skyrocketed.

Credit spreads between junk bonds and treasures have spiked higher.

Meanwhile the junk bond market failed to have a single new issue for the
second week in a row. There is simply no demand for the product.

This isn't 1998 all over again. We've gone beyond that.

    Today we do not have only a liquidity crisis like in 1998; we also have a
insolvency/debt crisis among a variety of borrowers that overborrowed
excessively during the boom phase...the recent sharp widening in corporate
credit spreads is not just a sign of a liquidity crunch; it is a sign that
investors are realizing that there are serious credit/solvency problems in
some parts of the corporate system.

If you needed any proof that there is a credit crunch in America today, look
at what is happening with credit cards.

    In a form letter, Capital One told her the interest rate on her credit
card was about to almost double—she’d been bumped up from a fixed 8.9 percent
rate to a "variable rate that equals the prime rate plus 6.9 percent"—or
about 15.8 percent. The letter blamed rising interest rates across the
economy for the decision.[...]

    As home prices across the United States have stagnated or fallen and
consumers have tapped out the equity in their homes, banks have gotten more
cautious about lending and have tightened their standards for new mortgages
and home-equity loans. As a result, more Americans are shifting debt onto
credit cards.

What makes this all worse is that this isn't just an American phenomenon.
Spain is leading europe into an "inevitable" real estate bust. The U.K. is
almost certain to follow, and their real estate bust could be even worse than
America's in degree. Other countries such as France, Australia, and China are
also facing the bursting of real estate bubbles.

What we can expect

Hindsight is 20/20, but forecasting what is to come is extremely difficult
and unreliable.

However, every once in a while the insiders will give you a clue. For
instance, just a month ago Treasury Secretary Paulson was in China begging
for them to buy our mortgage-backed securities. China, of course, refused,
but it gave a sign of just how bad things were going to get.

Another sign of things to come came from a reliable source.

    Fannie Mae and Freddie Mac, once derided as white elephants of the
mortgage market, are benefiting from the subprime-lending debacle and
trampling just about anything in their way.

    Now, the companies are getting praise in Congress after promising to
spend at least $20 billion to keep the mortgage market afloat by purchasing
loans made to people with poor credit histories or high debt burdens.

    "The political tide is definitely running in their favor," said David
Dreman, who manages investments including 12.8 million Freddie Mac shares at
Dreman Value Management in Jersey City, New Jersey. The companies "are
re-establishing their credibility," he said.

"Credibility" is not exactly what I would call it. Fannie and Freddie's
combined portfolio amounts to $1.5 Trillion already. Freddie Mac recently
revealed to have lost $550 million in the 3rd quarter of 2006, lost $480
million in the 4th quarter of 2006, and lost another $211 million in the 1st
quarter of 2007. Fannie Mae portfolio could be several times worse. The
mortgages they own are already risky and now they want to expand it as the
real estate market melts down.

    The Office of Federal Housing Enterprise Oversight estimates that 40.6
percent of Fannie’s portfolio, a total of $292 billion, is in loans for
low-income borrowers, first-time buyers, and people living in mobile homes
and economically distressed neighborhoods – all likely candidates for
mortgage foreclosure. Freddie owns $68 billion of these loans, some 9.5
percent of its portfolio.

    Unloading these properties is nearly impossible. Fannie has a Detroit
house on the market for $7,000, despite the $59,000 outstanding on the loan.
The property, repossessed in May, has been looted, with the kitchen sink and
drainpipes stolen.

Is this really the companies that will bailout the mortgage industry?
Companies loaded with massive defaults and an implied taxpayer bailout if
they fail?

But the real clue about where we are headed comes from the actions the Fed
took yesterday that I mentioned at the start of this diary.

The Fed "injected liquidity into the market" yesterday. The phrase sounds
innocuous, but its not. What it actually means is that the Federal Reserve
created short-term repurchase agreements in which they bought billions of
dollars worth of mortgage-backed securities.

Since the counter parties in these agreements have to buy back those MBS's in
a few days it is consider "market neutral", and the Fed's action with RePo's
is nothing more that pump-priming the market. But is it really?

The Fed's bond holdings continue to grow every year. How can that be "market
neutral" then?

If this still doesn't sound ominous then consider where the Federal Reserve
gets its money from - thin air. Here's how it works:

a) the Treasury issues bonds

b) the Federal Reserve creates the money from thin air and loans it to the

c) the Federal Reserve then creates more money from thin air and buys those
Treasury bonds back, thus becoming part of the Fed's bond holdings

And that's how money is created in America today. What's that? It sounds like
a scam? Yes, but its legal (and very profitable to a small number of banks).

There are other ways that money is created money is created in America today,
some less scary, some more scary. The problem is that the line between
"money" and "credit" has been (intentionally?) blurred. Where once the two
were very separate things, they now appear to be the same.

Somewhere between the blurring and the RePo's the Fed created a massively
expanding monetary stock that is nearly out of control.

Of course the Fed stopped reporting the M3 a couple years ago, just as it was
about to cross over 10% growth y-o-y. Then earlier this year the Treasury did
something rather ominous - they outlawed the exporting of pennies and
nickels. Why did they do that? Because the dollar has been so devalued by the
massive expansion of the monetary stock that the metal content of pennies and
nickels is worth more than their face value.

This has been very common in history when a government tries to "create
wealth" through uncontrolled fiat money printing. The difference this times,
as opposed to historical comparisons, is that in history the governments
outlaw ownership of precious metals. Our government has so devalued the
currency that they are outlawing the melting down of base metals. (our
government outlawed private ownership of gold from 1933 to 1974)

Happy Birthday!

Which brings us to an ironic anniversary. While the Federal Reserve is busy
monetizing debt by creating money out of thin air, today happens to be the
88th anniversary of the birth of the Weimar Republic.

The Weimar Republic in Germany has the dubious distinction of being most
known for printing their currency into oblivion in 1923. How did they do
this? Glad you asked. When the government needs more money than its people
are able or willing to lend it, it monetizes the debt. That is what happens
in this country when the government runs a big deficit. The Federal Reserve
(our central bank) "buys" as many bonds as necessary to stabilize the market.
It prints money on the security of these bonds. Despite the facade of the
government supposedly "borrowing," the net result is the creation of printing
press money. (Actually these days the money is created in the form of new
bank deposits--checkbook money--but the net result is exactly the same as if
bills were printed.)

This is what happened in Germany. The government issued notes which were
promptly discounted by the Reichsbank, i.e., the bank issued money on the
"security" of these worthless notes. To compound the evil, the bank failed to
raise its interest rate sufficiently. Businessmen found it very profitable to
borrow money from the bank and buy up goods, shares and companies. Their debt
was wiped out within weeks by the rapid inflation, and the businessman
remained holding the valuable assets he had bought. The net result was a huge
"private inflation" caused by the rapid expansion of credit. Even foreign
exchange was bought with borrowed money, so that the Reichsbank actually
financed speculation against its own currency. Yet the bank refused to raise
interest rates, arguing that this would only add to the cost of business and
thus would increase inflation!

Children playing with stack of worthless currency, Germany 1923

Woman burning stacks of worthless currency in her stove for heat, Germany

That's not to say this is our destiny. I'm only saying that the Fed and
Treasury have taken the first steps down that road. There is still plenty of
time to turn back.

But if people aren't aware of the road we are standing on, if the idea is
simply rejected out of hand without discussion, then how can the public's
outrage stop the government from leading us down the road that they have
already started?

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