Wealth destruction gathers
pace By Julian
Delasantellis
In the Old Testament story of
Exodus, the liberation of the Hebrews from slavery
in Egypt, those Israelites with the sign of the
blood of the lamb on their doorposts were spared
God’s wrath; those Egyptians without it were not.
Today, it is now apparent that the market for what
is called "auction rate securities" will not be
spared the wrath of the fearful God of credit
market crisis now wielding a terrible swift sword
over the world’s capital markets.
In this,
auction rate securities take their place alongside
the subprime mortgage market, the collateralized
debt obligation market, the market for asset
backed commercial paper, structured investment
vehicles, mortgage insurers, and undoubtedly many
more to come, laid low and to waste as the
unfolding judgment day continues and intensifies
for the great
credit creation boom of the
past 10 years.
If it is true that idle
hands do the devil’s work, then the skyscrapers of
Wall Street’s great houses of investment banking
must surely be among the holiest places on earth,
for lately they have been very busy indeed.
At its core, investment banking is a very
simple enterprise. On the one side are lenders,
those currently with money who are willing to
collect some measure of remuneration for deferring
their current consumption to some point in the
future. On the other side are the borrowers, those
who need and want money now and are willing to pay
interest to get their hands on it. Investment
banks bring the two groups together, and in doing
so are richly rewarded in the process.
But
in the same manner in which the average American
shopper now has more consumer choices available to
him in the cat food aisle than the average Soviet
consumer would have had in the whole store, the
top in their class Wharton MBAs and Massachusetts
Institute of Technology math PhDs ( those with
lesser grades had to settle for less important
work, like working for NASA) have fashioned a
dizzyingly diverse credit market architecture,
called financial engineering, in which the
transfer of money from lenders to borrowers could
occur as readily and as seamlessly as possible.
Do you have money to lend for a long
period of time, say 20 years, but don’t want to
get stuck lending at a low fixed rate in case
inflation and/or interest rates rise? That’s OK,
financial engineering’s solution to that is
adjustable rate borrowing. Do you have money to
lend, and you don’t want to have to worry about
whether it will get paid back, but you want to
earn a higher rate of interest than safe but low
yielding US Treasuries? The solution to that is
insured corporate borrowing, whether it to be
companies, students borrowing to pay their way
through college, car loans and the most recent
next big thing from 2003-06, real estate lending
to prospective borrowers with less than stellar
credit scores, now known with infamy as subprime
borrowing.
However, as I told my son as
the tow truck returned the first car his mother
and I bought for him belching smoke like a Russian
steel mill, for engines to work they must have
lubricating oil, and the lubricating oil for the
financial markets is money. For borrowers to
borrow the lenders must have money to lend, more
importantly, they must have the willingness to
lend.
In olden days generating money to
lend was accomplished the old fashioned way -
somebody earned more money than they spent, and
lent the rest.
So old
school With the Keynesian macroeconomic
revolution of the mid-20th century, national
governments took up some of the role of monetary
management once entirely left to the markets,
establishing in all the world’s major economies
central banks to lend money into the economy when
the private sources of capital were either unable
or unwilling to do so. The successful working of
this public/private arrangement funded the great
postwar economic boom that followed World War II,
but as government management of economic affairs,
like the reputation of government’s role in
society in general, came into disrepute with the
economic and social calamities of the 1970s, the
private sector came to see the big drawback of
relying on central banks to create money.
Like they say on American home-repair TV
shows, if you want something done, do it yourself.
Central banks will create only what they consider
is the appropriate level of liquidity, of money,
in the economy. What if you want more money than
the central banks are willing to create? In that
case, the banks had the idea, essentially, to
print their own.
The core mechanism here
was to initiate a process of daisy chain
leveraging, continually collateralizing each
previous iteration of borrowing and lending in
order to fund whole new successive levels of
greater borrowing and lending.
Enter the
math nerds, armed with their pocket protectors.
Their job was to create, to be the "financial
engineers" for such bewilderingly complex
successive sets of these debt instruments that
none of the lenders or borrowers getting into them
could honestly say that they really understood
what they were being sold. In the final analysis,
the investment houses pitched these new products,
called "financial derivatives" because their
ultimate value and worth was "derived" from the
value of other instruments, on the basis of the
perceived credibility and honesty of the
investment houses themselves.
The banks
were selling off their hundred-year or more
reputations for honesty and probity in order, as
was the true spirit of the time, to get rich fast,
and, whatever they may say now, while they were
doing so they loved every minute of it.
And so was fueled the first great economic
boom of the 21st century. Core economic theory
states that too much money seeking to buy too few
goods produces inflation, but with Chinese
production holding down the prices of everything
from tennis rackets to tubas the impact of the
added monetary firepower never really made it into
the inflation and cost of living statistics.
Where it was felt, however, was in the
market for real estate in America and in much of
the rest of the Anglo-Saxon world. Chinese
manufacturing became skilled in producing the
goods that Americans wanted to buy, but it
couldn’t produce those monstrous six-bedroom
4,000-square-foot New England colonial/Southwest
adobe fusion styled houses (Americans left that
task for the illegal immigrants it imported from
Mexico; see "Exurbia: Built on paradox and
hypocrisy, Asia Times Online, March 29,
2007) that sprawled across the landscape like
kudzu, and more importantly China couldn’t produce
new vacant land that the houses would sit upon.
The buyers with the financially engineered
cash burning holes in their pockets bid real
estate prices up, and that set up what was then
seen as a virtuous (these days it’s seen more as a
vicious) circle of real estate appreciation.
Rising prices tempted, then forced, other buyers
into the market, hoping to hop onto a trend for a
quick and easy killing. More importantly, the
mortgages on the properties with the rapidly
rising prices were bundled up and collected into
packages of bond-like derivative securities called
collateralized mortgage obligations.
With
home prices rising so rapidly, investors snapped
these up quick. Why shouldn’t they have? The
securities would maintain their value, and
continue to pay a very nice rate of interest, as
long as the mortgage borrowers, the people living
inside their homes, paid back their loans on time.
There was every expectation that they would, for
not to do so would mean being foreclosed out of
ownership of what was seen as modern suburban
goldmines.
Everybody knew that, in the
long term, annual home price rises of 20% or more
in the hottest local markets couldn’t last, that
they were unsustainable. Still, like denizens of a
Roman orgy in Pompeii seeing Vesuvius start to
belch and rumble, the insane pleasures of the
present were just too exquisite to entertain any
thoughts of the catastrophe soon to be bearing
down upon them.
About a year ago now, the
tide turned. House prices had risen so far so fast
that the most vulnerable borrowers, the subprimes,
could not afford the payments when their low,
initial "teaser" rates reset to the higher rates
and monthly payments they would carry for the full
terms of the mortgages. They defaulted on these
mortgages, and that caused the value of the
mortgage derivative bonds containing their
mortgages to fall sharply in value.
You
can think of the subprime mortgages as the
high-tide mark of the great credit creation bubble
on a warm summer’s day. As the water, the amount
of liquidity in the system, recedes, more and more
sea life is exposed to the sun’s hot rays - it
withers and dies. As the subprime mortgage paper
failed, the other derivative instruments, whose
value depended on the subprime mortgage paper
holding its value, were then uncovered, and were
shown in the final analysis not to have anywhere
near the intrinsic worth they were valued at.
From collateralized mortgage obligations
through collateralized debt obligations, asset
backed commercial paper, structured investment
vehicles, all the way to the mortgage and bond
insurers, they all depended for their value on
another derivative at the next link back on the
daisy chain. Like dominoes falling, like a video
of a building being built run in reverse, brick by
brick, the great wealth creation edifice of this
decade is being pulled down.
Last week, it
was the turn of what is called auction rate
securities. At a US Senate hearing, New York
Senator Charles Schumer asked why the Port
Authority of New York, the operator of most of New
York City’s transportation infrastructure, was now
being forced to pay annual interest rates of 20%
on a rollover of its debt, as opposed to the 3-4%
it usually paid. It could not be that the Port
Authority had suddenly become a poor credit risk;
check out the webcams of the Authority’s toll
bridges, tunnels and airports - they’re all as
busy as ever.
The problem was that,
instead of utilizing the standard, tried and true
markets for government agency debt, the Port
Authority was using the market for auction rate
securities.
The finance MBA definition of
auction rate securities states that they are
something of a strange hybrid of long-term fixed-
and short-term floating rate debt, but what you
really need to know to understand what’s going on
is that they are just another derivative product
produced by the math PhDs and marketed by the
investment houses. The failed offering by the Port
Authority was but one of 1,000 auctions of these
securities that last week sunk like a stone; the
big brokerage houses such as Goldman Sachs and
Merrill Lynch, the companies that had created,
peddled and promised to stand behind the auctions,
were, when they were most needed, nowhere to be
found.
Everything is interconnected. What
is going on here is that, as the crisis destroys
wealth with every sector of the credit markets it
ravages, less liquidity is available to fund every
succeeding sector in the rest of the credit
markets-they’re falling too.
When people
think of interest rates they think of the US
Federal Reserve, but what the Federal Reserve acts
upon and directly controls is but a very small,
and highly misleading, picture of the overall
health of the credit markets. For instance, since
September, the interest rate that the Federal
Reserve most directly controls, the Federal Funds
target rate, has declined by 225 basis points,
from 5.25% to 3%. Over that same period, the
interest rate for corporate bonds issued by
companies rated by Moody’s as Baa, not the best,
but still respectable, has actually risen, from
6.59% to 6.95%, with over half of that rise coming
just this past week.
The Fed, along with
the world’s other major central banks, is
providing liquidity to the markets by the
bucketful; too bad that just about none of that
money is getting to where it’s really needed - the
corporate sector. It’s being safely ensconced in
short-term risk free government Treasury
securities, a very prudent bet with fear pervasive
that loans to the private sector will be defaulted
upon and never paid back. The prospect of the
US$600 and up soon to be deposited in American
consumers’ hands by means of the recently passed
stimulus package is apparently impressing these
markets about as much as if during the World War I
somebody had suggested attacking dreadnoughts with
slingshots.
In and of itself, the market
for auction rate securities is not large, "only"
$330 billion out of the estimated total nominal
world value of the entire derivatives market of
over $500 trillion. (By comparison, only 22 of the
183 countries listed by the World Bank had a gross
domestic product greater than $330 billion, and
the estimated $500 trillion value of world
derivatives is more than seven times that of total
world GDP. If the derivatives markets stumbles or
falls, it could take a lot of the world economy
with it.)
The point here is that an
avalanche of credit and wealth destruction has
been created and continues to gain ever greater
and greater momentum as it rolls down the hill. In
another few weeks or so, another victim will be
inundated and lost (my money’s on credit default
swaps and the bond insurers such as MBIA as the
next to go), then more after that.
They
say that this year Americans are voting for
change. Unless some countervailing force can soon
be mobilized and employed to resuscitate and
return confidence to the credit markets, by 2009
the country will indeed look very changed, no
matter who’s in the White House.
Julian Delasantellis is a
management consultant, private investor and
educator in international business in the US state
of Washington. He can be reached at
juliandelasantellis@yahoo.com.
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