Posted on: November 26th, 2008 Time to Stop Feeding the Monster

In a democratic society the economy should work to support people rather than people working to support it.  Let’s not forget we invented the economy—every bit of it, from the creation of money and credit, to the way we keep score with double entry bookkeeping, to the notion of GNP and theories of monetary and fiscal policy.  When things go terribly wrong, as they have in recent months, we should be able to reinvent a functioning system not have it turn on us like some Frankenstein monster.

Our market system is exceptional.  It needs to be rescued.  But to function it requires good information and a clear connection between cause and effect.  We have lost that connection.  Nowhere is this more evident than the myth the sub-prime market was responsible for the current financial crisis.  The facts show that the market was neither large enough nor struggling enough to cause this chaos.

At the end of 2006, when large US mortgage lenders started to fall like dominoes, the entire mortgage market in the US was worth $10 trillion.  The sub-prime portion, and its close cousin the slightly better-heeled Alt A, represented 15% and 5%, respectively.  At its peak, when financial executives started to call in their insurance policies, the pool of high risks mortgages was about $2 trillion.

Let’s think about that.  The tab for the financial crisis in the US is $7.8 trillion.  For a quarter of the cost all homes underlying sub-prime mortgages could have been purchased outright.  The US could have had a housing program for its low and middle income families envied around the world, rather than what its ending up with; a corporate welfare scheme shoring up the bad decisions of a few hundred financial executives.

When the sub-prime mortgage market allegedly triggered this crisis, delinquency and default rates were lower than they had been in 2001-2002.  The problems could have, and should have, been contained and redressed well within traditional mortgage lending practices if the old rules of the game had been in play.  But they weren’t.

What’s changed?  Enter the monster.  In less than five years the rules of the game fundamentally changed due to the rise in power of derivatives markets and the underlying agreements embedded in the clauses of credit default swaps.1

A credit default swap is a contract between two parties where the buyer makes regular payments to a seller in return for protection.  Although credit default swaps are often referred to as insurance, unlike insurance which requires the insured party own the protected assets, the holder of the swap does not need to.  In fact, the buyer of protection does not have to suffer a loss to collect—all that has to happen is for a predetermined default event to occur and the buyer collects a payment.  The existence of these contracts on a wide scale, often providing multiple contracts for the same class of assets, has transformed the historical market incentive to accurately assess and underwrite risk into an incentive to disregard it.

Consider the impact credit default swap protection had on mortgage loans.  Historically the prudent course of action, even within the sub-prime sector, was to keep known risks within a certain range:  some would-be home owners were refused.  Not so when you have unlimited protection.  No income,  no job, no assets, no problem.  Prudent business practices got in the way of gobbling up market share.  The appetite of the derivatives market for new mortgages was insatiable, as it was for credit card receivables, car loans, or any other activity that could be leveraged into an ante-up for the default swap market.  The market was fattened up and then?  Well, the monster sunk its teeth in.

The majority of credit default swaps last 1-5 years with a sizable increase in volume starting in 2004.  It’s like these bets against the success of the economy were sitting on the shelf chanting “don’t forget our best-before date”.  Remember, these are like insurance contracts without the insurance checks and balances of responsibility.  Knowing your pool is insured if defaults begin to climb reduces significantly the desire to mitigate them, particularly if the negotiation process takes you past an expiry date.

This built-in disincentive to take prudent action in the face of adverse circumstances is known in insurance circles as “moral hazard”.  The greater the degree of coverage, the easier the claims process, the more likely the insured party will act in a hazardous fashion—will act irresponsibly.

An absence of consequence ruins prudent lending practice and destroys the incentive to workout a solution when borrowers face difficulty.  Renegotiating loans, behind closed doors and in good faith, has become old school.  In the past we could rely on renegotiation to contain a downturn.  Not any more.  It’s not so much that credit is unavailable, its that its going to feed the monster leaving the rest of the market to starve.

The unwillingness of lenders to renegotiate loans is now seeping into the consumer retailing sector causing large companies to head straight for bankruptcy rather than seek the useful protection of Chapter 11.  The closed door to renegotiation in the private sector is what causes companies to ask for government bailouts.

The recent $326 billion rescue package for Citigroup was in response to the company’s exposure to collateral debt obligations (CDOs).  Guess what, behind every synthetic CDO lurks a credit default swap, but its impossible to ascertain how Citigroup’s problems are in direct consequence of these obligations.  These contracts are generally held in entities not reflected on the balance sheet and the definition of credit events differ from contract to contract.  How, if and when they net out is important to know.  Based on their losses to date they’ve found themselves on the wrong side of protection way too often.  What we do know–a $25 billion problem grew thirteen times in a matter of weeks.

The powerful role credit default swaps play can not be overlooked in the recent requests for public aid from the top three auto makers.  Both US and Canadian governments are being pressured to come up with bailout packages.  What assurance is there that the money will not just go to the holders of swaps to pay off their positions?  These contracts have a tail and depending on their terms, financial institutions may be able to benefit many times over on the same pool of assets.  The nature of these agreements is that they thrive on instability and volatility.  When the tangled web of agreements are unwound its quite possible auto manufacturers will fail anyway because the rescue aid was not directed to its intended purpose.

Protection of industrial activity and jobs is critical, but if we continue to rescue entities who are lined up for slaughter to feed the economically unreasonable demands of derivatives contracts, we will not find the solutions we seek.  Until we reign in the derivatives mess we’re looking at taxpayers bailing out just about everything—except ourselves.  It’s time to stop feeding the monster.

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1.  In December 2004 the notional value of credit default swaps in the over-the-counter (OTC) derivatives market was $6.4 trillion (2.5% of the total notional value of all OTC derivatives contracts).  By December 2007 it was $57.9 trillion (9.7% of the notional value of all OTC derivatives) while credit default swaps to OTC derivatives contracts in terms of gross market values, went from 1.4% of the total in December 2004 to 14% in December 2007.  See Table 19, statistical appendix September 2008 and September 2007 Bank for International Settlements Quarterly Reviews.

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Posted on: November 15th, 2008 International Financial Crisis — Swimming in Quicksand

Watching pension savings deteriorate and home equity evaporate while hearing we can expect layoffs, decreased output and lower incomes in the months ahead, is leaving many feeling bewildered and confused. Being told this bleak future is a result of defaults in the U.S. sub-prime mortgage market—a market very few of us even knew about, much less participated in—only adds to the confusion. How bad and how long it lasts depends upon whether governments accurately identify the magnitude of the problem and how quickly they adopt appropriate policy measures to solve it.

On Wednesday, October 29, the Federal Reserve Board in the United States released a statement1 explaining its rationale for cutting the Fed funds rate to 1%. “Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures and official steps to strengthen financial systems should help over time to improve credit conditions and promote a return to moderate economic growth.”

Reassuring words, but unfortunately they belie the fact that the world’s most powerful central bank does not have a grasp on the problem we face. All policy measures focus on getting the free flow of credit moving. The Board believes that if they make money cheap enough, bankers will see the wisdom in lending to consumers and businesses, returning us to economic growth and price stability. After all, it worked to get us out of the tech bubble in 2001 didn’t it?

There is no possibility that monetary policy will work. The circumstances surrounding the current crisis are fundamentally different than ever before. It is not a flow of funds problem but a stock of funds problem. Until this is acknowledged the polite debate regarding the merits of monetary policy versus fiscal policy will drag on as the timeliness for implementing effective policy solutions becomes stale-dated.

Paul Krugman’s column2 on Friday, October 31 in the New York Times, identified the crux of the issue. Monetary policy could work “unless for some reason the Fed can’t offset the fall in consumer spending.” The reason the Fed can’t offset the fall in consumer spending is because the economy is drowning in a liquidity trap. “Fed policy has lost most of its traction…the financial crisis has made Fed policy largely irrelevant for much of the private sector: The Fed has been steadily cutting away, yet mortgage rates and the interest rates many businesses pay are higher than they were early this year. The ongoing efforts to bail out the financial system, even if they work, won’t do more than slightly mitigate the problem.”

What is desperately required is an expansionist fiscal policy by government which would protect people from foreclosures. Large scale foreclosures don’t just hurt individuals, they hurt entire neighborhoods. Current estimates suggest that as high as one in five U. S. homeowners hold mortgages that are greater than the resale value of their home. Policy makers should also significantly increase spending on health care, education, public housing, roads, bridges, rapid transit, and other forms of productive physical assets. This will create meaningful employment and generate income that is sorely needed.

There’s no doubt consumer spending has decreased and access to credit has fallen off. What doesn’t make sense is how quickly the trend changed and by how much. When sub-prime mortgage market failures hit the news it seemed shocking that so many defaults could occur so quickly. Usually the effects of a downturn take much longer to feed into the economy and there are warning signs. When people have difficulty paying their mortgages, banks try to avoid triggering the lengthy and expensive process of repossession. Not this time.

The circumstances of this credit crisis are fundamentally different because of underlying agreements embedded in the clauses of derivative contracts called credit default swaps. 3 These contracts transform the incentive to renegotiate loans for a troubled debtor into incentives to trigger their write-off and collect on insurance. Why bother renegotiating at a lower interest rate and longer term to maturity when you can get a higher return by collecting insurance on the entire amount outstanding? Renegotiating loans, behind closed doors and in good faith, becomes outdated.

The incentive to renegotiate loans has always provided a type of holding-tank protection for market adjustments. It keeps things in a flow of funds environment. Renegotiated loans may be akin to swimming in dirty water: not very comfortable but you can still do it. Write-offs are akin to swimming in quicksand.

In and of itself the disincentive to restructure, although significant, would not cause a full scale collapse of the financial services sector. Coupled with the unique features of the derivatives market which allowed too many swaps to be written on the same pool of assets without corresponding reserves to back them up has multiplied the problem. When one entity triggers a default it sets in motion a string of calls, each with the incentive to trigger other calls. Multiple parties held rights to what historically would have been a single string of payments. Reserves are eaten up very quickly and institutions fail. These multiple claims help explain why the U.S. Treasury bailout to financial companies is already close to $3 trillion while the amount needed to forestall foreclosures directly would have been much less. 4

Until the nature and magnitude of the problem is acknowledged, U.S. federal policy makers are going to think and act like monetarists while banks and other financial institutions continue to think and act like liquidators. Accordingly, calls for meaningful solutions for homeowners are going to go unheeded with their problems translating into problems for us all.

The need to acknowledge this disconnect between financial institutions and consumers becomes even more critical in light of the impending problems in credit card and auto loan receivables. The market for credit receivables, packaged as asset-backed securities, is structured much the same way as the sub-prime mortgage market. It’s very likely this will be the next shock to hit the market. It’s hard to imagine how an already weakened system will absorb the hit if the policy response copies that of the sub-prime mortgage crisis.

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1. Board of Governors of the Federal Reserve, The Federal Open Market Committee decided to lower its target for the federal funds rate 50 basis points to 1 percent, Press Release, October 29, 2008.

2. Krugman, Paul, When Consumers Capitulate, New York Times, October 31, 2008.

3. For a broader discussion of the implications of the derivatives market see Scott-Quinn, Brian and Walmsley, Julian K., The Impact of Credit Derivatives on Securities Markets, International Securities Market Association, Zurich, Switzerland, 1998. and Arthur D. Little, Demystifying the Credit Crunch, July 2008.

4. As of November 10, 2008 the bailout package is estimated at $3 trillion including a $700 billion fund to buy equity and assets of troubled financial companies and $1.5 trillion in a term auction facility. A fund of $300 billion has been set aside for direct assistance to homeowners at risk on future mortgages, but lenders have been reluctant to access these funds. See Where AIG’s New Bailout Ranks, CNNMoney.com, November 10, 2008.

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