Notes on the Train Wreck

Everyone knows something is wrong – home prices dropping so that your equity in the place, which was your financial cushion, can no longer be used to pay for whatever it is you thought you really needed, as there is no equity now, or you’re upside-down, owing far more on the home than it’s now worth, so even if you wanted out you’re not getting out. The number of home foreclosures is jumping up each month, as are bankruptcies – and everything costs more, oil at an all-time high so the gas for the car is a concern, and the wheat that goes into almost everything has tripled in price worldwide, and even that damned coffee you need is at a twenty-year high. You may not be one of the hapless or misled who took out one of those sub-prime mortgages, assuming you could refinance again and again because the value of that place you really couldn’t afford just went up and up – but you don’t need to be. You see the markets dropping and dropping – was that your retirement – and the dollar falling, as the rest of the world knows we have a mess here and would rather trade in other currencies. You hear the president say things are fine, that we’re just going through a rough patch, as he puts it, but you feel uneasy.

You can watch television, while you still have one, and find some release from the unease. But then, as Tom Weber explains at his Wall Street Journal blog, that’s a little surreal:

If you’re paying attention to the economy, television ads these days can have a “Pleasantville” quality. In that movie, Tobey Maguire and Reese Witherspoon play teenagers magically transported to a fictional town from a ’50s sitcom. Pleasantville is an innocent place, free of worry until the future kids arrive.

In TV ads at the moment, some of the fictional characters seem trapped in a yesteryear, too. It’s a time when the stock market was climbing, or at least holding its own, and recession seemed like a distant possibility. In this world of ads, most people are still living it up – though a few seem aware that not all is right.

But then on what should have been a weekend whem no one thinks about business, there was odd news:

JPMorgan Chase said Sunday it will acquire rival Bear Stearns in a deal valued at $236.2 million, a stunning collapse for one of the world’s largest and most venerable investment banks.

JPMorgan Chase & Co. said the $2 a share, all-stock deal has received the required approvals from the federal government and the Federal Reserve. Bear Stearns shares closed Friday at $30 a share.

The Fed will provide special financing to JPMorgan Chase for the deal, JPMorgan Chase said. The central bank has agreed to fund up to $30 billion of Bear Stearns’ less liquid assets.

What? They went under? And the buyer is paying seven cents on the dollar for the business, but doing that only because the government is tossing in thirty billion of taxpayers’ dollars to cover the crap Bear Stearns owns and the buyer will be stuck with? Yeah, those would be mortgage-backed securities, either worthless or so complex and subdivided and leveraged that no one knows what they’re worth at all – much the same thing as worthless, actually.

Things are bad, and this happening on a Sunday was ominous.

And, on the same Sunday, this too was ominous:

 

The Federal Reserve announced a series of new steps Sunday to help provide relief to a spreading credit crisis that threatens to plunge the economy into recession. The central bank approved a cut to its lending rate to financial institutions to 3.25 percent from 3.50 percent, effective immediately, and created another lending facility for big investment banks to secure short-term loans.

The steps are “designed to bolster market liquidity and promote orderly market functioning,” the Fed said in a statement. “Liquid well-functioning markets are essential for the promotion of economic growth.” The new lending facility will be available to financial institutions on Monday.

Well, Monday came early in the Asian markets – they all tanked. This was the meltdown they feared, with our Federal Reserve spending the weekend trying to slow it down with this and that.

Oh, it’s not that very interesting, unless you’re paying for the emergency measures, and you are:

 

So the question is: if Bear Stearns screwed up big time – as it did – with huge leverage, reckless investments, lousy risk management and massive underestimation of liquidity risk why should the US taxpayer bail out this firm and its shareholders? First fully wipe out those shareholders, then fire all the senior management and have the government take over such a bankrupt institution before a penny of public money is wasted in bailing it out. Instead now the use of public money to bail out financial institutions is spreading from banking ones to non banking ones. The Fed should at least give a clear and public explanation of why such extremely exceptional – and almost never used – intervention was justified.

Unless public money is used on a very temporary basis to achieve an orderly wind-down or merger of Bear Stearns this is another case where profits are privatized and losses are socialized. By having thrown down the drain the decades old doctrine and rule that the Fed should not lend or bail out non-bank financial institutions the Fed has created an extremely dangerous precedent that seriously aggravates the moral hazard of its lender of last resort support role. If the Fed starts on the slippery slope of providing massive liquidity support to non-bank financial institutions that have recklessly managed their risks it enters into uncharted territory that radically changes its mandate and formal role. Breaking decades-old rules and practices is a radical action that seriously requires a clear public explanation and justification.

But what is this about profits being privatized and losses being socialized? Is that what happened here, the government not messing with private profit, shrugging at regulation, by assuring we all chip in to cover losses? It would seem so.

Matthew Yglesias, from the left, offers this:

… speaking strictly as an ideologue, I don’t necessarily have a problem with the government intervening to bail a bunch of rich guys out when their own bad decisions blow up in their faces if that’s what’s needed for the health of the overall economy, but this sort of thing is one of several reasons why I think the very rich should pay high tax rates and we shouldn’t be happy about the prospect of ever-growing inequality. At a certain level, the game is rigged and you’re not really bearing any risk.

That’s why we have lobbyists, isn’t it? Someone has to suggest, and then pay for, ways to rig the game. The rich guys he mentions have lobbyists – it’s a low-cost high-return investment for them.

From the Associated Press, this is interesting:

Bear Stearns was the most exposed to risky bets on the loans; it is now the first major bank to be undone by that market’s collapse. But the fact that a major investment bank could reach the verge of buckling – and be sold at such a discount – sent dismay through Wall Street and beyond.

“One reaction is shock that a company that reaffirmed its book value at around $84 on Wednesday can be worth $2 per share four days later on Sunday,” said Deutsche Bank analyst Mike Mayo.

Worth 84 on a Wednesday, 30 at the close on Friday, and sold for 2 on Sunday – and the feds forced the sale. Why would they sell? Josh Marshall here considers why the Fed could “make” Bear sell at a price which some think is actually a bit too cheap:

 

One, that Bear Stearns execs were unwilling to go into bankruptcy because of the various forms of criminal liability they would face – and that everyone would be so pissed about the collateral damage of the bank’s collapse that everyone would want to not only execute them but also have them drawn and quartered (in case you only know the phrase and not what it actually means: not pretty). Two, there’s so much crap on Bear Stearns’ books that $2 per share is just a fair price, even with the Fed assuming a lot of the potential liability.

Is it all falling apart? With Bear Stearns gone, investors worried about who might be next. Lehman Brothers Holding fell more than thirty-four percent that Monday, following a fifteen percent drop on Friday – people assuming they be might next, facing comparable liquidity issues. The Lehman Chief Executive, Richard Fuld, denied Monday that the firm was having any such problems, just like the Bear Sterns guy the week before.

As for the possibility that the whole house of cards – that would be our financial system – might crumble (or topple, to use the right verb for cards), Andrew Leonard suggests this:

A couple of things to bear in mind while we watch and see what transpires this week. First: Bear Stearns was the canary in the coal mine. That canary is now dead. Whither Citigroup, or Merrill Lynch, the other standard-bearers of Wall Street that revealed big balance sheet disaster numbers all fall? Second: The exotic troubles experienced by Wall Street’s investment banks right now are a direct consequence of the housing bust and the subprime collapse and all the funny-money machinations with complex financial instruments that have now definitively been proven to be fool’s gold. How that distress intersects with high oil prices, high food prices, increasing stress in labor markets and other economic ailments much more familiar to the working man and woman is a narrative whose plot is just beginning to thicken.

Ah, the plot thickens. Heard it before, and very clever, but less than reassuring. Paul Krugman, the economist of note, writing on the Friday before this train wreck, seeing what was coming, makes things seem even worse:

 

I’m more concerned that despite the extraordinary scale of Mr. Bernanke’s action – to my knowledge, no advanced-country’s central bank has ever exposed itself to this much market risk – the Fed still won’t manage to get a grip on the economy…

I’m sure that Mr. Bernanke and his colleagues are frantically considering other actions that they can take, but there’s only so much the Fed – whose resources are limited, and whose mandate doesn’t extend to rescuing the whole financial system – can do when faced with what looks increasingly like one of history’s great financial crises.

The next steps will be up to the politicians.

I used to think that the major issues facing the next president would be how to get out of Iraq and what to do about health care. At this point, however, I suspect that the biggest problem for the next administration will be figuring out which parts of the financial system to bail out, how to pay the cleanup bills and how to explain what it’s doing to an angry public.

Well, don’t turn to Alan Greenspan, who used to run the fed, for an explanation. He’s useless:

 

The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

Kevin Drum offers an explanation:

This means, presumably, that he thinks we may be about to enter a recession worse than the one in 1981 – and that it’s not going to end until house prices stop falling, which probably won’t be until 2010 or so. This is bad, right?

The rest of Greenspan’s piece is basically a convoluted way of saying that Wall Street never expects the good times to end, but when they (inevitably) do, all the computer models that worked when prices were going up suddenly seize up and die…

In other words, all those risk management systems created by the rocket scientists weren’t designed to take into account the possibility that there was any actual risk in the system.

… The next big argument, I assume, is going to be between people like Greenspan, who essentially say there’s nothing we can do about this, and others who think that reining in the wild west of global finance a bit might be a useful thing to do. Count me in the latter camp.

And that Monday-after was a wild west day for the markets, as the New York Times relates here – the Dow Jones industrial average up slightly more than twenty-one points, after gyrating a few hundred point up and down, as ” investors started worrying about who and what would be next in the line of fire.” Oil dropped hard – if everything collapses folks will use less. Wheat futures dropped too – as no one may have much money to buy the stuff. Edward Rombach, an analyst at Thomson Financial, is quoted as saying this – “There is something mixed up in the market. The market is eating itself up.”

And this passage indicates the fixes might just not work:

Since last summer, the Fed has tried many approaches to ease the strain in the credit markets. It has cut its benchmark rate from 5.25 percent in a series of jagged steps. It has aggressively lent money to banks and accepted lower-quality collateral that might not even be tradable in the market.

Despite those efforts, financial conditions have worsened. And specialists say the latest measures might meet the same fate if banks and securities firms do not put to work the new money the Fed is offering to lend to them.

“The Fed can do no good at all if they effectively print money and give it to the banks, and the banks dig a hole in the ground and put it in there,” said Donald Brownstein, president of Structured Portfolio Management, a hedge fund in Stamford, Conn., that specializes in mortgage securities.

No one wants to play in this sandbox, and you can see why, with the tale of MF Global, one of the world’s biggest commodities brokers:

Its shares fell $11.30, or 65 percent, to $6.05, on rumors that it was losing clients and rival firms were refusing to deal with it.

Last month, MF Global announced that a trader had lost $141.5 million betting on wheat futures with money he did not have. The firm had turned off risk controls for some traders because the controls slowed transactions.

Reassurances from the New York Mercantile Exchange and the United States Commodity Futures Trading Commission that MF Global remained on sound footing did little to stem the negative sentiment.

Well, they turned off risk controls for some traders because the controls slowed transactions – and that can make people nervous.

And nervous people look for someone to blame for the current pickle we’re in, as in a companion article – “President Bush on Monday welcomed the Federal Reserve’s sweeping intervention in the nation’s financial markets as his administration faced accusations that it had supported the bailout of a prestigious investment bank while doing little to address the hardships of Americans facing foreclosures on their homes.”

You can imagine what the Democrats said, especially the two running for president. The Republican running, who has repeatedly said he doesn’t know much about economics at all, did his I’m-with-George thing – laissez-faire economic policies keep things humming nicely, except for the few times they don’t, so you should leave things alone.

That’s what the president had said just the Friday before all this, at his speech at the Economic Club of New York. The New York Times editorial in response was titled Through Bush-Colored Glasses:

President Bush admitted on Friday that times are tough. So much for the straight talk.

Mr. Bush went on to paint a false picture of the economy. He dismissed virtually every proposal Congress is working on to alleviate the mortgage crisis, sticking to his administration’s inadequate ideas. And despite the rush of serious problems – frozen credit markets, millions of impending mortgage defaults, solvency issues at banks, a plunging dollar – he said that a major source of uncertainty today is whether his tax cuts, scheduled to expire in 2010, would be extended.

Yep – that’s it. Make the tax cuts for the rich permanent and let things work themselves out.

Hey, out here in the San Francisco area, people are figuring out ways to work things out:

A Discovery Bay man who asked not to be identified said he is “upside down” on his house by about $260,000. Instead of bemoaning the situation, he plans to capitalize on it.

“‘I refinanced a couple of years ago and pulled out $100,000 and put in a fabulous pool,” he said.”‘Now I’ve got this fabulous pool and fabulous house, but it’s not worth anything. Why shouldn’t I be building equity over the next four to five years instead of playing catch-up?”

The man said he has not made a mortgage payment for five months.

 

“I’m playing the bank game,” he said. “I’m playing chicken with them. I already got them to agree to put (the unpaid) payments on the tail end of the loan. What I’m really pushing them to do is to (adjust my mortgage) for the current market value and write off the rest. I’d love (to have it) lopped down to a $450,000 basis rather than $710,000.”

 

If the bank won’t negotiate, he’ll walk away, the man said.   

 

That might work. See Daniel Gross and The Rise of American Incompetence  – “We used to be the world’s most skillful entrepreneurs and managers. Now we’re laughingstocks. What happened?”

This happened: 

 

But now, thanks to widespread incompetence, American management is on its way to becoming an international laughingstock. Faith in American financial sobriety has been widely undermined by the subprime mess. The very mention of the strong-dollar policy now elicits raucous bouts of knee-slapping in even the most sober Swiss banks. (How do you say schadenfreude in German?) Earlier this month, as oil hovered near $100 a barrel, President Bush complained to OPEC about high oil prices. OPEC President Chakib Khelil responded acidly that crude’s remarkable run had nothing to do with the reluctance of Persian Gulf nations to pump oil, and everything to do with the “mismanagement of the U.S. economy.” Since Bush’s plea, oil has gushed to $110 per barrel. (How do you say schadenfreude in Arabic?)

The concern extends beyond airlines to America’s industrial complex. Doubtful of the ability of provincial American executives, with their limited language skills, to negotiate today’s global business environment, the boards of massive U.S. firms like Coca-Cola, Pepsi-Cola, Alcoa, and insurer AIG have hired foreign-born CEOs. Carl Icahn, the 1980s corporate raider, has reinvented himself as a borscht-belt comedian/activist investor, who delights conferences and reporters with jokes at CEOs’ expense. On a recent 60 Minutes, Icahn complained to Lesley Stahl about the incompetence of American management. “I see our country going off a cliff, and I feel bad about it.”

So does Andrew Leonard in The Crash in Republican Economics – “Not even George W. Bush or Alan Greenspan can sugarcoat America’s financial meltdown. Will the next president seize the chance to rethink how we run our economy?”

He hopes so:

The New Deal didn’t emerge of its own accord as some kind of organic reaction to the Great Depression. Leadership was required, and the political fights were brutal. The same will no doubt be true for any sustained effort to crack down on Wall Street shenanigans and redistribute wealth more equitably. Indeed, for most of the past 25 years just imagining such a thing would have seemed ludicrously out of touch with political reality. But that’s what makes the current events so dramatic. The dangers – of great economic distress and turmoil – are clear and intimidating. But the opportunity for reform is fantastic.

In the interim we’ll get things like this:

Joseph Nacchio was the CEO of Qwest Communications, and seven months before 9-11 (let me repeat, BEFORE 9-11), he and his company were asked to assist the US government in providing access to their communications networks without a warrant. Of all the telecoms, Nacchio and Qwest were the only ones to refuse. The government consequently pulled a bunch of their top-secret contracts and generally made it impossible for Qwest to do business. The stock dropped precipitously, and later federal prosecutors arrested Nacchio for insider trading, for having sold a significant amount of his holdings before the stock tanked. He claimed that he was actually trying to raise capital to exercise options and buy more stock, as he expected the government contracts to be renewed. This all went to trial and Nacchio was convicted last year.

But the same Monday, the 10th Circuit Court of Appeals reversed the conviction. There will be new trial with a new judge – the old one excluded evidence from an expert witness that would have validated Nacchio’s claims. And as “dday” at Hullabaloo continues:

In a new trial, even more information about the Bush Administration’s efforts to immediately conduct massive spying on American citizens upon the moment they entered office will come to light. The goal was total information awareness, an enormous drift net of data that could be used to any of a thousand pernicious ends. Among the evidence that could be provided are those secret contracts and communications on why they were cancelled, and when.

This is why you don’t give blanket amnesty to lawsuits where the truth about illegal spying and surveillance could emerge.

But that’s the only regulation we seem to get – so the train wreck unfolds before us. You can turn your eyes away – economics is dry stuff – but they do call economics the dismal science for a reason. This stuff matters more than Hillary’s ego, Obama’s pastor, or McCain’s war record.

 

 

About Alan

The editor is a former systems manager for a large California-based HMO, and a former senior systems manager for Northrop, Hughes-Raytheon, Computer Sciences Corporation, Perot Systems and other such organizations. One position was managing the financial and payroll systems for a large hospital chain. And somewhere in there was a two-year stint in Canada running the systems shop at a General Motors locomotive factory - in London, Ontario. That explains Canadian matters scattered through these pages. Otherwise, think large-scale HR, payroll, financial and manufacturing systems. A résumé is available if you wish. The editor has a graduate degree in Eighteenth-Century British Literature from Duke University where he was a National Woodrow Wilson Fellow, and taught English and music in upstate New York in the seventies, and then in the early eighties moved to California and left teaching. The editor currently resides in Hollywood California, a block north of the Sunset Strip.
This entry was posted in Bush, Class Warfare, Economic Issues, Recession, Regulation, Sub-Prime Crisis, The Economy, The Financial System. Bookmark the permalink.

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