Moral Suasion and the Markets
Note: As most of you regular readers know, I have taken to the habit of posting clips of important news to your financial future at the beginning of my post. Because of the recent events there is quite a run-up from August 05, my last posting to this post. These clips are a fascinating story unfolding of to the lead up to the biggest market collapse since the Great Depression. See the financial storm brewing. After these news clips is my commentary. For those of you new to this blog, the current theme about the economy began in April of ’08. To get an in depth analysis of what is going wrong and why the rules are changing, begin in April.
Inflation outpaces rise in U.S. consumer spendingConsumer spending grew by 0.6% in June, but that gain was wiped out by inflation rising by 0.8%, the biggest monthly increase since September 2005. "That real consumer spending is down two-tenths in June is not a good thing in and of itself, but it also is a bad thing for what it means for third-quarter consumption," JPMorgan Chase economist Michael Feroli said. The New York Times (05 Aug.)
U.S. home prices could fall additional 33%, analyst saysU.S. home prices could fall by an additional one-third before mortgage lending resumes with gusto, a widely respected analyst said. "Home prices are going to fall much more than people expect," Oppenheimer analyst Meredith Whitney said. CNBC (04 Aug.)
What sounded alarmist a year ago is fairly accurate nowAs the Financial Times continues its look back over the credit crunch that began one year ago, it delves even further back into the recent history of investment banking, hedge funds and how the financial industry has changed. "This has been a very deep and unusual crisis that involves the unwinding of a decade of excess. The impact on the financial sector has been 7 on the Richter scale (a 'major' earthquake), as dramatic as anything for 25 years," said Bill Winters, co-head of the investment bank at JPMorgan Chase. Financial Times (04 Aug.)
IMF reduces forecast for growth in BritainThe International Monetary Fund dashed Alistair Darling's hopes for a quick recovery of the U.K. economy by lowering its forecast for growth and by warning of two more years of economic woes. Additionally, the fund said rising inflation gives the Bank of England little room to adjust monetary policy to bolster growth. The IMF also said the Treasury is on course to reach next year the national-debt limit of 40% of GDP, in a warning to the chancellor that he won't be able to borrow his way out of economic pain. The Times (London) (07 Aug.)
Credit crisis persists as banks take more hitsThe credit crisis continues to affect some of the biggest banks on Wall Street. UBS, Citigroup and Merrill Lynch have taken massive write-downs, and investors are still worried about more subprime costs. Although lower oil prices have lifted stocks, it apparently will take more than cheaper energy to boost consumer spending and business. CNBC/Reuters (12 Aug.)
U.S. health care expenses expected to jump 10.6%Health care costs in the U.S. are predicted to increase 10.6% next year. Employers have lowered many costs of health coverage with sizable investments in wellness programs that help prevent expensive critical care. FinancialWeek (12 Aug.)
Federal Reserve's concern about inflation continuesThe Federal Reserve said inflation is still a top concern, even as energy prices fell recently. Given the unimpressive growth rate, plus inflation, a recession is still possible for the U.S., although some officials see declining oil prices as keeping inflation under control. Reuters (12 Aug.)
The Cold, Hard Numbers on the Credit Crunch
RealtyTrac shocked Wall Street with the most explosive news imaginable:
U.S. home foreclosures skyrocketed an astonishing 55% in July ...
One in every 464 American homes went into foreclosure last month alone ...
A staggering 750,000 abandoned homes are now begging for buyers nationwide — a clear sign that prices will continue to plummet and that ever-increasing numbers of homeowners will walk away in the months ahead ...
Fed Loan Officer Survey Shows Widespread Tightening!
Every quarter, the Fed releases a report called the "Senior Loan Officer Opinion Survey on Bank Lending Practices." It quantifies how many banks are tightening standards, and on which types of loans. The third-quarter survey was conducted in July; 52 domestic banks and 21 foreign banks with operations here in the U.S. responded.
Inflation outpaces rise in U.S. consumer spendingConsumer spending grew by 0.6% in June, but that gain was wiped out by inflation rising by 0.8%, the biggest monthly increase since September 2005. "That real consumer spending is down two-tenths in June is not a good thing in and of itself, but it also is a bad thing for what it means for third-quarter consumption," JPMorgan Chase economist Michael Feroli said. The New York Times (05 Aug.)
U.S. home prices could fall additional 33%, analyst saysU.S. home prices could fall by an additional one-third before mortgage lending resumes with gusto, a widely respected analyst said. "Home prices are going to fall much more than people expect," Oppenheimer analyst Meredith Whitney said. CNBC (04 Aug.)
What sounded alarmist a year ago is fairly accurate nowAs the Financial Times continues its look back over the credit crunch that began one year ago, it delves even further back into the recent history of investment banking, hedge funds and how the financial industry has changed. "This has been a very deep and unusual crisis that involves the unwinding of a decade of excess. The impact on the financial sector has been 7 on the Richter scale (a 'major' earthquake), as dramatic as anything for 25 years," said Bill Winters, co-head of the investment bank at JPMorgan Chase. Financial Times (04 Aug.)
IMF reduces forecast for growth in BritainThe International Monetary Fund dashed Alistair Darling's hopes for a quick recovery of the U.K. economy by lowering its forecast for growth and by warning of two more years of economic woes. Additionally, the fund said rising inflation gives the Bank of England little room to adjust monetary policy to bolster growth. The IMF also said the Treasury is on course to reach next year the national-debt limit of 40% of GDP, in a warning to the chancellor that he won't be able to borrow his way out of economic pain. The Times (London) (07 Aug.)
Credit crisis persists as banks take more hitsThe credit crisis continues to affect some of the biggest banks on Wall Street. UBS, Citigroup and Merrill Lynch have taken massive write-downs, and investors are still worried about more subprime costs. Although lower oil prices have lifted stocks, it apparently will take more than cheaper energy to boost consumer spending and business. CNBC/Reuters (12 Aug.)
U.S. health care expenses expected to jump 10.6%Health care costs in the U.S. are predicted to increase 10.6% next year. Employers have lowered many costs of health coverage with sizable investments in wellness programs that help prevent expensive critical care. FinancialWeek (12 Aug.)
Federal Reserve's concern about inflation continuesThe Federal Reserve said inflation is still a top concern, even as energy prices fell recently. Given the unimpressive growth rate, plus inflation, a recession is still possible for the U.S., although some officials see declining oil prices as keeping inflation under control. Reuters (12 Aug.)
The Cold, Hard Numbers on the Credit Crunch
RealtyTrac shocked Wall Street with the most explosive news imaginable:
U.S. home foreclosures skyrocketed an astonishing 55% in July ...
One in every 464 American homes went into foreclosure last month alone ...
A staggering 750,000 abandoned homes are now begging for buyers nationwide — a clear sign that prices will continue to plummet and that ever-increasing numbers of homeowners will walk away in the months ahead ...
Fed Loan Officer Survey Shows Widespread Tightening!
Every quarter, the Fed releases a report called the "Senior Loan Officer Opinion Survey on Bank Lending Practices." It quantifies how many banks are tightening standards, and on which types of loans. The third-quarter survey was conducted in July; 52 domestic banks and 21 foreign banks with operations here in the U.S. responded.
Some 74% of banks surveyed said they're tightening standards on prime mortgages, up from 62.3% in the second quarter of 2008. A net 84.4% said they were cracking down on nontraditional financing, up from 75.6%. And a net 85.7% said they were tightening on subprime loans, up from 77.7% a quarter earlier.
These numbers are off the charts. The previous record for the home mortgage category was 32.7% in 1991. So in plain English, you have more than twice as many banks tightening standards now than EVER before.
* The trend is spilling over into commercial real estate. This is no longer just a subprime mortgage crunch. In fact, it's not even a residential real estate crunch. The Fed's commercial real estate (CRE) figures prove it.
A net 80.7% of survey respondents said they were tightening standards on CRE loans. That was up from 78.6% a quarter earlier and the highest on record.
* Consumer credit is tougher to come by. The story is the same for credit cards, auto loans, boat loans, and other forms of consumer credit. Some 66.6% of lenders said they were tightening standards on credit card borrowers. That was up from 32.4% a quarter earlier and the highest since the Fed began collecting data in 1996. 67.4% are making it tougher to get other consumer loans, up from 44.4% and another record. Money and Markets by Mike Larson August 15, 2008
Economists: Taxpayers likely to bail out Fannie, FreddieThe consensus of 53 economists polled by the Wall Street Journal is that there is a nearly 60% chance that U.S. taxpayers will have to prop up Fannie Mae and Freddie Mac. The main mortgage-finance providers in the U.S. should be pushed to raise capital privately, said seven out of 10 economists surveyed. One in three said Freddie and Fannie should be nationalized and then sold off in smaller chunks when the housing market recovers, the newspaper reported. Bloomberg (15 Aug.)
Gas more expensive than cars for U.S. consumersIn May and June, U.S. dollars spent on gas surpassed money spent on cars and parts for the first time since 1982. The last time gasoline was such a large component of personal spending was in September 1982 during an energy crisis set off by the 1979 Islamic revolution in Iran, the second-largest oil producer of OPEC. Record prices at the pump have decreased U.S. gasoline demand, at a five-year low, and also affected consumer spending, including auto sales. Bloomberg (15 Aug.)
Concerns mount with U.S. inflation still on the riseMany were betting that slowing consumer demand coupled with declining energy prices would help smooth inflationary pressures, but last month saw U.S. consumer prices rise twice as fast as predicted, in the largest surge since 1991. This situation further emphasizes the predicament of the Federal Reserve as it tries to balance the risks of increasing cost of living with growing unemployment, the credit crunch, and a weakened consumer. Financial Times (14 Aug.)
Signs of economic slowdown pile up in Asia, EuropeGermany's economy is contracting, the Bank of England offered a dismal outlook and Japan seems to be near a recession. More bad economic news is expected in Europe this week. Although commodity prices are starting to come down, consumers are feeling the pressure from financial crises in the U.S. and elevated inflation. Experts said the U.S. economic slowdown is spreading through Europe and Asia. International Herald Tribune (14 Aug.)
Shrinkage of U.S. money supply causes further concernWith the U.S. money supply seeing its most acute contraction in modern history, there is a more heightened risk than ever of a severe economic slowdown. This comes on top of the current credit crisis and at a time when overall debt burden in the U.S. economy is at record levels. The acuteness of the drop, versus the absolute level, is what monetarists find most disturbing. Telegraph (London) (19 Aug.)
Former IMF economist predicts failure of large U.S. bankFormer International Monetary Fund chief economist Kenneth Rogoff expects to see a large U.S. bank fail in the next few months, estimating more trouble for the U.S. economy. "I think the financial crisis is at the halfway point, perhaps. I would even go further to say, 'The worst is to come,'" he said at a financial conference. Rogoff also said the Federal Reserve was wrong to slash interest rates as "dramatically" as it did. Reuters (19 Aug.)
Freddie Mac's bond sale underscores severity of crisisFreddie Mac paid a yield of 4.172%, 113 basis points over Treasuries, on a five-year debt issue to raise $3 billion. It is the highest risk premium that Freddie has paid, highlighting the severity of the U.S. housing crisis. Investors have demanded higher yields because of uncertainty in the market as well as questions about moves that the government might make regarding the government-sponsored enterprise. Financial Times (20 Aug.)
U.S. walks tightrope between inflation, recessionThe U.S. is battling inflation and a recession simultaneously as higher costs for food and energy affect nearly all products, increasing consumer prices. Some economists see the slowdown as an antidote for inflation; others see inflation as a continuing threat. Options for the average American are that either inflation will reduce their buying power or rising prices will spell the end of some jobs and businesses. The New York Times (19 Aug.)
SEC plans to broaden short-selling ruleThe Securities and Exchange Commission aims to propose a new short-selling rule in upcoming weeks, broadening an emergency order -- covering 19 financial stocks -- that ended last week. SEC Chairman Christopher Cox said the proposal "will focus on marketwide solutions" and possibly require more transparency in disclosing to the public significant short positions in stocks. Reuters (19 Aug.)
Cramer of CNBC suspects insider trading of Fannie, Freddie: CNBC's Jim Cramer called for a suspension in trading Fannie Mae and Freddie Mac stocks on the grounds that insider information was circulating. Cramer blamed the Securities and Exchange Commission and the New York Stock Exchange for not taking action when it seemed obvious that insider trading was happening. CNBC (20 Aug.)
Gold becomes solid as oil prices climb, dollar dropsThe combination of a falling dollar and higher oil prices has raised gold's appeal as the precious metal is expected to have its largest weekly gain in seven years. "In the short term, at least for another month or so, gold will stay in this consolidatory phase of rebounding on price drops and falling when gains get too much," said Lin Yuhui of China International Futures. "These movements will largely continue to be driven by movements in the U.S. dollar and crude oil." Bloomberg (22 Aug.)
Libor-OIS spread indicates credit crunch to continueThe spread between the three-month London interbank offered rate for dollars and the overnight indexed swap rate is at 77 basis points, up from 24 basis points in January. By mid-December the spread is expected to widen to 85 basis points. Alan Greenspan, former chairman of the Federal Reserve, said the spread should indicate when the markets have returned to normal. According to forward markets, that won't be for quite some time. "It's like an ongoing nightmare and no one is sure when we're going to wake up," said Stuart Thomson, a money manager at Resolution Investment Management. "Things are going to get worse before they get better." Bloomberg (25 Aug.)
Banks, firms pay more to raise money in bond markets Dismal economic conditions around the world, increasing default rates and concerns about the health of financial institutions are forcing yields to rise as bond investors demand higher spreads. According to Lehman Brothers, risk premiums for investment-grade companies and banks in the U.S. recently reached their highest level since the 1990s. Spreads in Europe and Asia for some investment-grade companies have hit 10-year highs as well. ClipSyndicate/Bloomberg (22 Aug.) , Financial Times (24 Aug.)
Central bankers acknowledge uncertainty of crisis: At the gathering of central bankers and other economic experts in Jackson Hole, Wyo., this weekend, the consensus was uncertainty as to how the credit crisis and other woes will ultimately affect the global economy. Policymakers from around the world seem conflicted as to whether resilience in the global economy will win out or if the worst is yet to come. Financial Times (24 Aug.)
Analysis: U.S. economic woes hinge on home buyersThe difference between a mild downturn of the U.S. economy and a severe recession depends on the ability and willingness of consumers to quickly return to the housing market, according to this Reuters analysis. In order for home prices to be in balance with incomes and rents, economists say they need to drop another 10%. However, prices could fall even further if Fannie Mae or Freddie Mac meltdown, or if private lenders tighten requirements. Depending on how far home prices fall, the U.S. could suffer a consumer-led recession. Reuters (25 Aug.)
Economists: Inflation tops credit crunch as greatest threatA survey of the members of the National Association of Business Economists showed inflation to be the chief concern, ahead of the mortgage and credit crises. Of the respondents, 15% see overall inflation as the greatest threat to the economy, and 16% find energy prices to be the greatest short-term threat. CNN (25 Aug.)
White House to keep pushing for stronger yuanThe Bush administration said it will continue pressing China to allow the yuan to appreciate more quickly. The yuan has strengthened 6.7% this year against the U.S. dollar and has appreciated 17% in the past two years. Bloomberg (26 Aug.)
Banks report second-lowest quarterly earnings since 1991Banks posted their second-lowest earnings performance since 1991 for the quarter from April to June, the FDIC reported. Earnings for the quarter tumbled 86.5%, from $36.8 billion a year ago to $5 billion this year. MarketWatch (26 Aug.)
British pound sliding toward $1.50 against dollarThe British pound could fall as low as $1.50 against the U.S. dollar in the next few years. The pound fell to $1.8386, the first time it slid to less than $1.84 since mid-2006. The decline came as the economic slowdown continues and foreign investors increasingly pull out of Britain's economy. Telegraph (London) (26 Aug.)
Canada doesn't meet forecast for quick growth in Q2Canada's economy apparently grew less quickly in the second quarter than the Bank of Canada predicted. In July, policymakers forecast that GDP would expand at an annual rate of 0.8% in the second quarter. The bank gave no new expectation for growth. The Globe and Mail (Toronto) (26 Aug.)
Central bankers acknowledge uncertainty of crisis: At the gathering of central bankers and other economic experts in Jackson Hole, Wyo., this weekend, the consensus was uncertainty as to how the credit crisis and other woes will ultimately affect the global economy. Policymakers from around the world seem conflicted as to whether resilience in the global economy will win out or if the worst is yet to come. Financial Times (24 Aug.)
Analysis: U.S. economic woes hinge on home buyersThe difference between a mild downturn of the U.S. economy and a severe recession depends on the ability and willingness of consumers to quickly return to the housing market, according to this Reuters analysis. In order for home prices to be in balance with incomes and rents, economists say they need to drop another 10%. However, prices could fall even further if Fannie Mae or Freddie Mac meltdown, or if private lenders tighten requirements. Depending on how far home prices fall, the U.S. could suffer a consumer-led recession. Reuters (25 Aug.)
Economists: Inflation tops credit crunch as greatest threatA survey of the members of the National Association of Business Economists showed inflation to be the chief concern, ahead of the mortgage and credit crises. Of the respondents, 15% see overall inflation as the greatest threat to the economy, and 16% find energy prices to be the greatest short-term threat. CNN (25 Aug.)
White House to keep pushing for stronger yuanThe Bush administration said it will continue pressing China to allow the yuan to appreciate more quickly. The yuan has strengthened 6.7% this year against the U.S. dollar and has appreciated 17% in the past two years. Bloomberg (26 Aug.)
Banks report second-lowest quarterly earnings since 1991Banks posted their second-lowest earnings performance since 1991 for the quarter from April to June, the FDIC reported. Earnings for the quarter tumbled 86.5%, from $36.8 billion a year ago to $5 billion this year. MarketWatch (26 Aug.)
British pound sliding toward $1.50 against dollarThe British pound could fall as low as $1.50 against the U.S. dollar in the next few years. The pound fell to $1.8386, the first time it slid to less than $1.84 since mid-2006. The decline came as the economic slowdown continues and foreign investors increasingly pull out of Britain's economy. Telegraph (London) (26 Aug.)
Canada doesn't meet forecast for quick growth in Q2Canada's economy apparently grew less quickly in the second quarter than the Bank of Canada predicted. In July, policymakers forecast that GDP would expand at an annual rate of 0.8% in the second quarter. The bank gave no new expectation for growth. The Globe and Mail (Toronto) (26 Aug.)
Retail stock ownership in U.S. falls to record lowRetail investment in U.S. stocks has hit a record low, showing that institutional investors will play a bigger role in domestic equity markets. At the end of 2006, the last year for which figures were available, individual investors owned 34% of all shares and 24% of stock in the top 1,000 companies, and institutions held 76% of the shares, up from 61% in 2000, according to a report. Financial Times (01 Sep.)
U.S. takes over Fannie, Freddie to stabilize mortgage market Source: CNBC The U.S. government placed Fannie Mae and Freddie Mac in a conservatorship Sunday and replaced their CEOs in a drastic move to stabilize lending in the mortgage market. Treasury Secretary Henry Paulson said the rescue is necessary because allowing either company to fail would trigger worldwide market turmoil. "This turmoil would directly and negatively impact household wealth: from family budgets, to home values, to savings for college and retirement," Paulson said. CNBC (07 Sep.) , The New York Times (registration required) (07 Sep.) , Financial Times (08 Sep.) , Bloomberg (07 Sep.)
In July, consumers borrowed about half as much as forecastConsumers in the U.S. borrowed about $4.6 billion in July. The median estimate of 35 economists surveyed by Bloomberg News was an increase of $8.5 billion in consumer credit for the month. Consumers borrowed $11 billion in June. "A slowdown in the supply of credit is one of several factors that we think argues for a slowdown in consumer spending," said Zach Pandl, a Lehman Brothers economist. "There will be a period of weak consumer spending ahead." Bloomberg (08 Sep.)
Former Fed official calls Fannie, Freddie takeover a "stopgap": The government's seizure of Fannie Mae and Freddie Mac is an attempt to keep them running into next year, when the new president and Congress can determine their future. "Some of this is a stopgap to try to prevent the mortgage market from falling apart," said William Poole, former president of the Federal Reserve Bank of St. Louis. Poole also said it is "an unacceptable situation" to have a shareholder-owned company with taxpayers covering risks. Bloomberg
Interbank lending dries up over renewed fearsInternational money markets are once again under severe pressure as fears about the financial system were renewed with the bankruptcy of Lehman Brothers and other developments. "Sentiment is incredibly negative. It is getting much harder to raise money with the cost of funding getting more expensive," said Dominic White of fund manager Morley. "Banks are reluctant to lend out cash in this climate. It is difficult to predict whether the strains will increase or ease, but it is likely to remain difficult for some time for most institutions that want to raise cash with this much uncertainty." Financial Times (15 Sep.)
Analysis: Fed may cut interest rate after drama on Wall StreetFederal Reserve officials met Monday after the weekend's dramatic events in the financial industry and discussed an interest-rate cut, possibly in conjunction with other central banks. Before the latest turmoil on Wall Street, most officials speculated that the next move would be a rate increase. But after the weekend's events, there are concerns about a downward spiral, and a rate cut is more likely. Financial Times (15 Sep.)
Fed loosens emergency-lending standards in Lehman's wakeThe Federal Reserve dramatically loosened standards for emergency loans to investment banks to head off concerns in Monday's markets about fallout from Lehman Brothers' Chapter 11 filing. The central bank said it will not offer cash to potential buyers of Lehman. Meanwhile, 10 major banks worldwide agreed to contribute $7 billion each to an emergency fund that could be used if any of them faces problems similar to those facing Lehman. The New York Times (15 Sep.)
Central banks prepare to counter potential financial turmoilIn the wake of the U.S. banking crisis, the European Central Bank and the Bank of England announced that they are prepared to intervene in financial markets if necessary. "The ECB stands ready to contribute to orderly conditions in the euro money market," the ECB said. The Bank of England said it will carefully monitor the sterling money market. The ECB also announced that it will offer markets unlimited overnight liquidity. Financial Times (15 Sep.)
SEC to strengthen rule on short sellingThe Securities and Exchange Commission plans to move forward on creating permanent regulations for abusive short selling. The SEC will likely underscore the short-selling rule as well as shorten the time in which traders must buy back stock if they fail to deliver a security by the settlement date. The plans came about after Lehman Brothers was forced to file for bankruptcy and the U.S. government took over Fannie Mae and Freddie Mac. Reuters (15 Sep.)
Regulators propose rule changes to deal with crisisRegulators at four U.S. agencies proposed rule changes this week to stabilize financial markets and beef up the balance sheets of financial institutions. Regulators and the White House decided to ease accounting rules to help the banking industry cope with issues that some experts said stemmed from deregulation. The Securities and Exchange Commission issued guidelines for propping up money-market accounts and imposed new short-selling limits. The New York Times (free registration) (17 Sep.)
Voters, businesses appear to welcome more regulation: The Federal Reserve's rescue plan for AIG, coupled with a similar plan by the Treasury Department for Fannie Mae and Freddie Mac, could mark the end of 30 years of deregulation by the federal government. The government's involvement in financial markets follows similar shifts in food safety, airlines and trade and signals that increased regulation is now more acceptable to businesses and voters. BusinessWeek (18 Sep.)
CDS market to take hit from Lehman's bankruptcyMarkets are about to see just how accurate Warren Buffett's statement is about derivatives being "financial weapons of mass destruction," as fallout from Lehman Brothers' bankruptcy begins. The Economist explained how a bankruptcy of this size may affect the market for credit-default swaps, an arena that grew in recent years to a $62 trillion behemoth. The Economist (18 Sep.)
Emerging markets saddled with backlog of maturing debtDuring the next year, emerging-market economies will need to refinance about $111 billion of bonds, raising the likelihood of defaults and other problems. "Many corporates and banks in the emerging markets are highly levered without cash to fall back on. These will struggle should they need to raise money in the markets," said David Spegel, ING's global head of emerging markets strategy. "The bond and loan markets are much harder to access now, and it could get worse, which means there will be defaults." Financial Times (21 Sep.)
Moral Suasion and the Markets
Bigger than the dot-com bust? Yeps. Bigger than Black Monday in 1987? Yes. Bigger than the oil shock of the 1970s? Yes.
Well, this has been quite a year for your portfolio! If you have been following this blog since April, you understand what has happened and why. Simply, Government has created an empire of debt that has to be managed. Clearly, it has been mismanaged. People are responsible, and herein is the problem. “We” keep changing the rules to worship a GROWTH economy, rather than a SUSTAINABLE one. Good stewardship of the land, the sky and the seas is what “we” don’t do. “We” don’t hold ourselves accountable to the value of sustainability. We buy and sell our way into the value of a short-term growth economy at the expense of our children’s future, don’t “we”?
That’s the way this system works, like it always has, until it doesn’t. Don’t we continually change the rules to serve special interests where the rich get richer, and you know the rest? Don’t we invest for a gain in value, and don’t we look first at an investment’s financial return, and then the fundamentals to answer the question, is it sound? Do we ever ask if it serves our environment sustainability criteria first? If it does, then it follows that it would also stand to benefit the good of our communities, the infrastructure of our society, as well as individual shareholder value.
There is a disconnect between our ability to comprehend a financial economy in the context of an environmental one. This is not only GREEN but it is social responsible behavior to our future generations. The core problem is that it is our nature to “misplace” our values when it comes to the ethical choices we make in the name of the dollar first.
I am guilty of this. I want more… stuff. And it is easy for me to enjoy these tangible things, even if I know that they don’t serve the environment or my children’s future in a friendly and sustainable way. I want more return too. Oil is an obvious example of this trade off between the short-term positive return from the financial investment and the long-term negative return to the environment. Additionally, our short-term thinking colludes with our short-term greed and then there is at some level, a sell out to the value of sustainability. There is no surprise that the current market mess is in the financial sector and that it is in the Empire of Debt.
This current market crisis is precisely why those who espouse the virtues of a free market - need regulation, most especially, short-term speculators! Because short-term speculators in the market are allowed without regulation, to take enormous leveraged positions ($57.9 trillion), they threaten to undermine the very system that ironically supports them and gives them the freedom and power to do this. Today, with that power unchecked and with a government policy of deregulation all the way back to Regan economics we have this problem, 30 years in the making.
Guess what is the quick, politically expedient short-term solution? Why it is massive infusions of inflationary new capital, $1 trillion in more debt to still more future generations and while all this is preoccupying our attention, there is the negative consequences to our environment that we think we don’t have to be responsible to till we take care of our current problem. Am I right?
Philosophy and history lessons behind us, if you have your money in some financial institutions you may be thinking, how did this happen. Well, it relates to the collapse of the home mortgage market and derivatives. These are essentially bets on interest rates, foreign currencies, stocks or specific events like the bankruptcy of a particular company. The interest rate-related bets are by far the biggest. But the bets on bankruptcies — called credit default swaps — are the fastest growing and the most volatile.
These derivatives were originally designed to help hedge investments reduce risk — like insurance policies. But in practice, they've been increasingly used to leverage investments, increasing the risks of participants, again, all for short-term gain.
For a relevant explanation I defer to Mike Larson. In his most recent email he writes and explains this.
“It's been quite the eventful week on the bailout front. The Treasury and Federal Reserve drew the line at Lehman Brothers, allowing the fourth-largest broker in the U.S. to file for bankruptcy.
Then a couple days later, the Fed backtracked and arranged an $85 billion bailout of American International Group. The idea is to keep AIG afloat while it sells assets to raise money.
As I've been discussing for a long-time, crummy residential mortgages ... troubled commercial mortgages ... and all kinds of other souring loans are causing a huge chunk of the problems in the banking and brokerage industry. But in the case of AIG, something else is at work. It's an obscure kind of contract that, behind the scenes, is wreaking havoc throughout the financial industry.
And I want to talk about these "CDS" — or Credit Default Swaps — today.
How Credit Insurance Works
I'm sure you know how traditional insurance works. After all, you have some combination of homeowners insurance, life insurance, auto insurance, and maybe even a policy on an RV, a boat, or a motorcycle. You pay a monthly, semi-annual, or annual premium to an insurance company. And the company invests that money to generate returns. If a catastrophe strikes — you get in a car crash, your house burns down, or you die — the insurance company pays you or your heirs a lump sum of money.
I'm sure you know how traditional insurance works. After all, you have some combination of homeowners insurance, life insurance, auto insurance, and maybe even a policy on an RV, a boat, or a motorcycle. You pay a monthly, semi-annual, or annual premium to an insurance company. And the company invests that money to generate returns. If a catastrophe strikes — you get in a car crash, your house burns down, or you die — the insurance company pays you or your heirs a lump sum of money.
It's a pretty straightforward business.
But in the past few years, many Wall Street firms, hedge funds, and companies like AIG plunged headlong into the Wild West World of CDS.
CDS operate like insurance on a bond or other security. Let's say you're a portfolio manager who owns $100 million in XYZ Corp. bonds. You read the paper, and you see that the industry XYZ is in is faltering, with sales declining and profits falling.
As a result, you might be concerned about the possibility that XYZ will default on the bonds you're holding. But for one reason or another, you don't want to sell your bonds and move on. So instead, you go into the market and buy CDS to protect you against the possibility of default.
You — the credit protection buyer — would pay periodic premiums (just like you and I do on life or car insurance) to a credit protection seller. If XYZ does NOT default, then the seller just collects his premiums and makes a decent return. If XYZ does default, then the seller either takes the bonds off your hands, paying you face value (regardless of where they're trading), or he pays you a cash settlement that makes you whole.
Either way, you as the buyer are protected from catastrophic loss — just like a homeowner is protected from catastrophe by his policy when his home burns down.
The Flaws in the System
Sounds good, right? But here are the problems...
First, CDS aren't highly regulated like the traditional insurance market is at the state level. In fact, the CDS market isn't really regulated at all. "Complacency is now unprecedented and regulators are asleep at the switch. The Securities and Exchange Commission says it has no direct supervision of trading in credit derivatives. The Commodity Futures Trading Commission also says it isn't responsible. The International Swaps and Derivatives Association (ISDA) says the industry can policy itself. We're not so sure."
Second, the CDS market exploded in size over the past several years. According to the British Bankers Association, the CDS market expanded from just $180 billion in 1996 to a stunning $20 trillion a decade later. That's a 111-fold expansion in this esoteric, opaque market. And by all accounts, it continued to grow LAST year as well — to a whopping $57.9 TRILLION, according to the Bank for International Settlements.
Third, the CDS market morphed into a vehicle for massive speculation on corporate credit rather than a way to hedge downside risk. Investors started buying CDS on companies with worsening credit — expecting those contracts to rise in value — and selling CDS on companies with improving credit — expecting to record a gain as those contracts declined in value.
Fourth, the quality of counterparties in the CDS market deteriorated substantially. What do I mean? When you bought your last homeowners or life insurance policy, you probably checked the credit rating of the company selling that policy. After all, what good is insurance if the company standing behind it can't make good on claims?
The problem is that more and more CDS were being bought and sold by hedge funds and other thinly capitalized companies during the boom days. This excerpt from a recent Minyanville column pretty much sums up the problem:
"A hedge fund trader once told me that they insured/sold 50 times their capital in CDS with the counterparty being a very large, well-known investment bank. "When I asked him if he was worried about that kind of leverage, he responded by saying that is the bank's problem because if he is wrong about writing all these insurance policies (in the form of CDS), they can only lose their investment capital in the fund." Comforting, eh?
The Fallout is Spreading
So how does AIG fit into all this?
Well, it sold protection on a mind-boggling $441 billion of fixed income securities. $441 billion! According to Bloomberg, almost $58 billion of those contracts referenced securities tied to subprime mortgages. That's what really brought AIG to its knees — the exposure to the CDS market.
Who else has massive exposure to credit derivatives?
According to a Fitch Ratings report from last year, the top five counterparties on CDS contracts (as of 2006) were:
Morgan Stanley,
Goldman Sachs,
JPMorgan Chase,
Deutsche Bank, and
ABN Amro.
To understand why, put yourself in the shoes of a senior derivatives trader at a big firm like Morgan Stanley (which has $7.1 trillion in derivatives on its books and about $10 billion in capital).
Let's say you're personally responsible for $500 billion in derivatives contracts with Bank A, essentially betting that interest rates will decline. By itself, that would be a huge risk. But you're not worried because you have a similar bet with Bank B that interest rates will go up. It's like playing roulette, betting on both black and red at the same time. One bet cancels the other, and you figure you can't lose.
Here's what happens next...
Interest rates go up, reflecting a 2% decline in bond prices. You lose your bet with Bank A.
But, simultaneously, you win your bet with Bank B.
So, in normal circumstances, you'd just take the winnings from one to pay off the losses with the other — a non-event.
But here's where the whole scheme blows up and the drama begins: Bank B suffers large mortgage-related losses. It runs out of capital. It can't raise additional capital from investors. So it can't pay off its bet. Suddenly and unexpectedly ... You're on the hook for your losing bet. But you can't collect on your winning bet. You grab a calculator to estimate the damage. But you don't need one — 2% of $500 billion is $10 billion. Simple.
Bottom line: In what appeared to be an everyday, supposedly "normal" set of transactions ... in a market that has moved by a meager 2% ... you've just suffered a loss of ten billion dollars, wiping out all of your firm's capital.
Now, you can't pay off your bet with Bank A — or any other losing bet, for that matter.
Bank A, thrown into a similar predicament, defaults on its bets with Bank C, which, in turn, defaults on bets with Bank D. Bank D has bets with Morgan Stanley as well ... it defaults on every single one ... and it throws your firm even deeper into the hole.”
And so it goes, until it doesn’t! Enter the Fed bailout, yet again, this time we are in for a one trillion dollar bailout, increasing liquidity in the system for the short term. Again, this is short-term, inflationary and we haven’t even talked about commercial real estate foreclosures, energy prices or the environment, they are next. Keep you power dry and keep smiling… until next time.
