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Tuesday, February 10, 2009

Credit system feeds derivatives monster

Credit system feeds derivatives monster

Tim Geithner's plan hit the street today. As of midday, Wall Street has taken the news badly.

Geithner said credit isn't available, but is this really such a bad thing? The contraction of credit is a natural response to over-lending, which appears not to be as big of a menace to government as it has been to the banks who actually have to account to shareholders. Our government appears to have lost any sense of responsibility in preventing a worsening deficit. Over the long-term our existing debt, combined with the borrowing that will surely come, renders our currency valueless.

The damage caused by a lack of credit is lost opportunity, or a consideration of future value created only in the imagination. In other words, what we will lose, we never really had. Losing anticipated growth and revenue isn't the same as losing real profits unless of course future debt is commoditized, turned into its present value. If money doesn't represent an asset, but rather a debt or future repayment, it will lose value when the chance of repayment drops.

The crisis we face today emerged because we've changed the way we spend money. Rather than represent a fiat currency whose quantity can be changed at will, unprecedented growth in private lending has created a massive unwieldy beast, a mammoth mountain of derivatives.

The Fed can only react to the overabundance of derivatives and instruments out there, which has created a de facto equivalent of currency. Neoclassical economists like Geithner and Bernanke believe they can increase the flow of money by increasing its release through TARP. And in Obama's stimulus bill we see the same thinking: government spending more (especially when people stop to spend) will thereby make more money available.

What if the credit money supply has dwarfed the supply of real money? After all, so much of the banks' lending is based on simple computer entires. If it's really grown, it might take trillions to compensate for the collapse. This could explain the unprecedented amounts that are being proposed. If there are perhaps 10 dollars in derivates for every one in circulation (part of the M1 money supply perhaps), repairing the crisis might require tens times as much.

Now Bernanke is clearly familiar with Keynesian approach; the devaluation of money since the last Depression shows just how much of its purchasing power it has lost over time. So, if the economy in inflation-adjusted terms were now ten times bigger, we'll probably need a New Deal times ten! I'm guessing spending (and not just on TARP and banks either, but real money going to real working people) could go to $10 trillion easy. Say hello to my little friend, inflation.

Another angle: maybe the response to the Great Depression was limited by the fact that our currency was backed by gold. With our unbound fiat currency, no such limitation exist on the issuance of new money today. At least New Deal problem-solvers could claim they hadn't decimated the purchasing power of our currency--an achievement that today's government policymakers will be lucky to prevent.

Looking at Keen's article in nakedcapitalism.com, I would guess the number of derivatives well beyond $150 trillion. Therefore to make a commensurate impact on stabilizing such a huge amount would require many spending on a scale perhaps hundreds of times larger than any precedent.

Unhinged, the US money supply--expressed in its broadest form M3, a statistic the US government stopped tracking a few years ago--the number of "dollars" out there grew by many multiples. Readers won't be surprised to hear that it was the Federal Reserve's loose money policy that led to the bubble, nor that Bush's political agenda to increase home ownership, in turn increased the velocity of money.

Velocity is as relevant to inflation as quantity. As long as the mammoth mountain of derivatives can be supported by the issuance of more debt, everything stays stable. The status quo is therefore a constant and growing expansion of "money," which we all know is not in effect money but rather a computer ledger entry, perhaps in the back halls of some faraway sovereign bank. As long as the sheiks let the money pile up--to pay for the oil--and the Chinese continue to purchase our bonds, the monster stays satisfied.

Should something go wrong, say sub-prime securities go bust, the effects can be cascading and damage the entire system. This explains why Bernanke testified in Congress that the Bear Sterns bailout was so needed--to prevent all the creditors under debt mountain from getting crushed by its weight. The systemic risk also explains how CItigroup was able to fandangle so many billions out of the Saudi sheiks shortly before its disastrous stock price collapse. If we don't pour more money in, the monster will consume everything, or so they could say.

The US monetary system has entered a crisis point because rather than base our money on asset, we've based it on credit. I read a good article by Steve Keen (link above) on the evolution of credit money. Ron Paul and people like Peter Schiff and Roubini have been on this point for years. Rather than assume that the Fed can control the money supply by issuing more debt, economists need to realize the supply of Federally-issued debt is but one small piece of all monetary equivalents out there.

Fair valuation

The sheer quantity of derivatives astounds. As one example, JP Morgan has derivatives in the sum of $90 trillion!

We don't yet know how to value those assets--a big reason why the banks' share prices struggle. More than mistakes, the stock market detests uncertainty. Until potential investors have measuring tools and transparency by which they can assess the worth of an enterprise, they will stay away and the stock price languish unless, of course, some entity indifferent to profit or loss--our government perhaps?--comes in and starts to plow money into them, regardless of their investment worthiness.

This is precisely how the first round of TARP "worked" and at least Geithner has the sense to stop trying to subsidize the banks' share prices. The private hand of market which Republican disciples of laissez faire capitalism praised, will do its job to make banks attractive by lowering their stock price. At no point, has the opacity of TARP helped, but rather hindered the fair valuation of the banks (unless of course they'd become worthless.)

The lack of transparency masked some of the dealings of our government in Act One of TARP, back under the Bushites. Obama may offer a change on this front of incalculable benefit. Despite their self-presumed defenders of the free market system, our last Republican administration actually prodded this whole collapse along, by keeping their activities secret. Investors likely fled the financial stocks because they couldn't find out what would happen.

Banks have always been prone to secrecy, and they often use their political influence to keep their dealigns secret. The industry may also be prone to an overabundance of caution, particularly when investor confidence is involved. If the slightest risk of financial insolvency should lead to the slightest stir of market innuendo, banks will be the first to attempt to quash it.

More than protecting the assets of the bank, banking is concerned about perception, or the concept that investor money is safe. The roots of this paranoia lie in the history of banking; nervous depositors have routinely made based runs on their banks based on hysteria. Public confidence is therefore vital, and the safeguarding of it abandoned reluctantly, or not at all if the administration and banking industry are as tightly bound as they were under Bush and the GOP.

Transparency is a vital part of appealing to investors, and Geithner appears committed to getting banks finances into the public view.

Government solution or more problems?

Like me, Geithner spent some time in Tokyo during the Nineties, where he saw firsthand how government intervention to prop up the economy could backfire. The Japanese poured huge loans into the banking industry. This created moral hazard because the bankers who held massive amounts of bad loans kept those loans on their balance sheets, rather than writing them off. Knowing they could count on government money, the Japanese banks were reluctant to act and disinclined to change, and proceeded to feed even more money to the recalcitrant borrowers.

Sure credit can flow out of the banks, given enough government assistance. But as Geithner admitted, government doesn't run banks very well. So at least he knows the limitations of government lending to the banks. This of course doesn't mean that he can afford to let the banks fail, but neither can he let the status quo maintain itself, creating a "Lost Decade" like the Japanese.

Unfortunately we have a heckuva lot of status quo to get through before the problem can be conquered. The issue as it turns out is derivates, a form of private credit money created when financial institutions buy or sell rights to future income. See, rather than just wait around til the checks come, the banks got cute and started selling each other IOUs, to jack up short-term profits. To make matters worse, these derivatives came with insurance, called Credit Default Swaps, that insured the holder of the derivative in the event of a loss.

The holders of the derivatives packaged their IOUs with the insurance, then sold them to other banks. Eventually, everyone was in the business of both issuing derivatives and insuring them, an unanticipated consequences of the Financial Modernization Act in 1999, which mergers brokerages and banks. Profits zoomed, particularly on the backs of mortgage-backed securities, including subprime, alongside complicated Structured Investment Vehicles (SIVs).

Naturally when the sub-prime market blew, so did the value of the mortgages on which the derivatives were built. The insurance that was supposed to protect the holders of the bundled mortgages turned out to be worthless on account of the fact it had been issued too broadly, and inadequately capitalized in the event of market-wide failure.

In short, greed led us to where we are. Trying to squeeze additional profits out of the bottom end of the mortgage market led to the broader collapse in the derivatives markets. Now with well over $100 trillion in derivatives, the issue is becoming how to get out of even bigger collapses.

The first step needs to be better regulation. Banks and brokerages should be denied the right to bundle mortgage-backed securities or sell in derivatives whose values can't be rigorously tracked at any given time. Without knowing the value of a security, it can't be sold, creating an illiquid asset. The lack of transparency can be attributed to the banks' general distaste in exposing the scope of their derivatives trading.

Everything rises or falls based on leadership

A wise businessperson who helped mentor me said that the first act of a qualified CEO moving into a distressed situation should be to fire those in charge, since they got them into the situation. While of course this approach is something of a
mischaracterization--the CEO might not have caused the problem--it does help simplify things. And simplifying things is exactly what the banking industry needs.

Unfortunately, Obama elected to put many of the people who held leadership roles in regulating the banking industry--like Bernanke and Geithner, former head of the New York Fed--into the top positions responsible for overseeing the recovery. Not gonna work. The vested interests that helped push profitability to new heights using innovative derivative trading schemes will be the last ones to admit they'd made mistakes, especially when the scope of their failures is so epic.

Again it's a matter of leadership. The Federal Reserve/banking industry's Old Guard has been responsible for creating the mess. A good new CEO fundamentally understands the need for change. New wineskins for new wine, that kind of thing. Until the people who got us into this mess are identified, ostracized, and punished, no new solutions will likely work.

I've said that Obama has been inclined to work with the Washington establishment in order to achieve change from within. While a noble, conciliatory gesture, this approach may not really expedite much. And as I've also said, the President needs to be able to achieve change on a rapid basis, cut through all the bureaucratic inertia and partisan bickering. While a "I'm the President--do it now" approach might not appeal to the intellect of the professor-turned-President, he needs to wield his authority decisively, and toss out anyone affiliated with the creation of the derivatives mess. Until then, his leadership will be inundated with Bush leftovers, and consensus picks who don't really have change anywhere on their agenda.

At the same time, Obama need not bring in total outsiders. There have to be hundreds of highly qualified economists better able to manage this crisis than Geithner and Bernanke. I for one nominate my International Finance professor at Thunderbird, John Mathis, chief economist at Continental Bank before its collapse. He exemplifies the kind of dignity we need back at the top, someone of integrity and respect that comes from outside the Washington establishment.

Until we get qualified people at the top, we'll be unlikely to engineer much of a solution. The vested interests are well simply too well vested. The Establishment politics are too infested with self-dealing and protecting reputations/covering up mistakes to purge the wrong-doers. Yes, some sacrificial cows like Lehman Brother's CEO Fuld will be brought forth, but those responsible for the greedy practices and abandonment of regulatory standards are too well intertwined with the establishment to present any real solution which has at its heart the need for change in the way banks do business.

Much of this problems has come out of the Reagan myth that deregulation is good for business. When we dropped the laws that kept brokerages and banks apart we created massive new money-making opportunities. Yet we also allowed the banking system to take unprecedented risks and over-leverage themselves to the point the derivatives they owe or are owed exceed by many multiples their depository base.

The solution has been decoupled from the cause and thereby distorts the alternatives available.

Heart of the problem

Defining the problem has been at the root of the solution. Geithner and Bernanke define their mission as one of restoring the credit markets, and getting credit to flow. To wit they pour trillions into the coffers of private lenders. Some of that money in turn goes to buy regional banks, consolidating the industry and eliminating competition. Meanwhile investment banks pour billions in bonuses away, as if 2008 had been a banner year for the industry.

It's as if a public health policy person were to say that the problem was AIDS. I might say, "no, it's an absence of safe sex." While the health bureaucrat might deal the the effects of getting AIDS, they fail to understand its cause and can do little to stop its spread. I, on the other hand, would confront the cause straight away--unprotected sex.

Geithner and Bernanke are now saying they must deal with the shortage of credit--the disease. I would say the locking up of the credit markets is simply the manifestation of an overextended credit system--the cause. Now the chief difference is in the application of relief: in my definition it would be to stop the over-expansion of lending; in the neoclassical view held by our government, it would be to lend more. [Ultimately the process of lending can be achieved both through Federal Reserve lending and through government borrowing, since to pay for any stimulus, we must borrow.]

Can the creation of more debt lead to a solution? While treating AIDS patients is clearly humane, does that stop the spread of the disease? We need to define the proper problem in order to craft the appropriate solution. As long as our government presumes the problem to be a lack of credit money, how can we cut down on how much we borrow, and thereby keep the mountain of debt from getting even bigger, a plague for the next generation.

Debt has a nasty habit of seeming quite manageable but in fact worsening almost imperceptibly over time until the day it sneaks right up on you. Take my word for it--I've been there. If you're relying on debt to fund your day-to-day existence, the pain will be that much greater when the credit runs out.

As a nation we've become credit junkies. As it probably should, the day has approached when our credit has run dry--we simply can't borrow any more. We do however have a completely indefensible target--using the credit of our unborn children. By borrowing way beyond our ability to repay we can get through our time here on this earth, albeit at the cost of untold years of toil by our descendants, carrying the burden of our unpaid taxes.

Yes, the deficits we run are that straightforward--damaging, and emblematic of where we stand as a people. Myopic, we've chosen the looking glass and ignored the debt crisis that we are brewing for the next generation and those unborn.

Easier it is to deny the scope of our debt than to face it down. Easier it is to believe that the problems of today eclipse those in the distant future, forseeable though they may be.

Harder we must all try to understand the scale of our momentous debt problem. Without understanding that the growth of debt is the cause of our problems, we continue to rely on more borrowing to sustain our way of life, one forged not with the fruits of labors but rather with spending money we never had or made, for things we didn't make, or sell abroad.

If we keep feeding the debt monster it will only grow hungrier. We must terminate our ever-worsening dependency on credit, whatever the cost. Real economic growth can't come from cheap money; we can't build economic strength based solely on IOUs and promises to pay. Now more than ever we need a economic cornerstone based on vital economic truth and justice, to confront the problems of our age, not leave them for others to clean up.


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