Ingredients for an Economic Katrina
By William Neil
April 23, 2008 - 12:12pm ET
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The following pieces, a cover letter from Aug. of 2007, and the essay to which it refers, from Feb. 2007, show my basic worries - before the financial storm hit - about the soundness of our financial system. My writing was triggered by a Washington Post "all's well" economic forecast which I saw in Jan. of 2007. Because far too much of our economic life depends upon finance and more specifically speculative finance, and too few close to "the street" will speak to the dangers, I've taken up the role of "citizen economist," and have lamented the left's inclination to believe that the major economic questions are "settled," to use the smug conclusion of George Will. Readers can judge for themselves how close events since Aug. of 2007 have come to my conclusions of Feb. 2007.
August 10, 2007
Back in February, I prepared, and previewed among a very small audience, a brief essay called Fiscally Responsible Or Ingredients for An Economic Katrina? Despite the fact that the sharp late February world-wide stock plunge was an early clue to deeper problems, I felt the time was not ripe to issue the essay. Today, the essay is needed to help citizens and elected officials understand what is about to unfold, with an unknown bottom.
While we all know now that the collapse of the subprime mortgage market has been the trigger, and will be an ongoing downward pressure as the bulk of the adjustable rate mortgages are rewritten (and defaulted upon) and come due starting in October and proceeding, month after month in 2008, the real worry now I think shifts to the major banks and hedge funds who are intertwined with the credit markets. This goes well beyond the mortgage category, and my essay walks you through what the fault lines are likely to be: "system freeze" where investors want to bail out and funds close down either because they cannot pay or they cannot "mark to market" - which simply means they can't even price what their previous bets (and bets upon bets) are worth at the end of the day. There is also the very real possibility that some institutions, hedges and banks, are reluctant to look too closely at what they have wrought is actually worth...and that is very dangerous as w ell...In my essay I describe the "test market run" for this fiasco in the collapse of Delphi, the auto parts dealer...where just one problem firm involved tens of thousands of separate deals to value and unravel...this problem is now moving towards being systemic...you multiply the parties involved, especially if they are all trying to rush for the exits at the same time....
I especially want to thank those courageous individuals who have warned about this situation starting many years ago with authors William Greider, and Kevin Phillips; economist Robert Shiller (whom I cited in my testimony warning the MoCo Council of its real estate dreams and dangers on June 26th, that "the storm warnings are already posted in the business pages of the Wash. Post and Robert Schiller's second edition, Chapter Two, of Irrational Exuberance...") and most recently, economist Dean Baker who was predicting a recession based on the housing market a year ago and now leans towards a more severe recession, and who was kind enough to read an early draft of my essay - the conclusions of which I alone am responsible for. These authors' works, and more, are listed at the end of my essay, with commentary.
For those of you who, in the August heat, are more comfortable with a video insight into where we are, and are possibly headed, I refer you to the many differently edited versions of Jim Cramer, the high energy TV stock market commentator, whose 5-8 minute "meltdown" plea to Fed. Res. Chairman Bernanke from last Friday afternoon has foreshadowed what has come. He's on UTube, of course, but just Google "Jim Cramer meltdown" and you'll see how widely his "moment" traveled.
Please make your own judgments on Mr. Cramer, but listen carefully to something he reveals about all economic moments like the one we are now in...as true in 1929 as today: it is hard to find the truth behind the morale stabilizing "posture." Note that Jim first berated the honesty of the Bear Stearns conference call from last Friday, meant to reassure investors, for disclosing that "it was the worst credit market in 22 years," shouting that they can't say that in a crisis like this....and then he himself discloses he's been talking to all the brokerage houses and they are telling him it's a disaster - off the record, of course....leading to his plea for Federal Reserve intervention - which has happened. So, my read: Jim was telling the truth about the behind the scenes assessments that we can't share with the public. This is very serious and uncharted economic terrain. I hope the brief essay can provide you with a few reference points to understand the jumble of new terms that analysts will, belatedly, be tossing around as they scramble to explain how this could have happened.
Your thoughts and reactions are appreciated.
Biographical Note (March, 2008)
William Neil is the former Director of Conservation for NJ Audubon Society. He served on Governor Martin O’Malley’s Transition Team for Planning and Smart Growth and was a candidate for the Democratic Seat on the Montgomery County Planning Board. He serves on the Steering Committee of Democracy For Montgomery County and ran a GOTV operation election week in 2006. His most recent essay, “A Citizen’s Guide to the Missing Green Rail Vision for the MD/Metro DC Region” (Jan. 2008) calls for a National Infrastructure Bank as one major response to “Where Three Crises Meet,” the concluding section of the 68 page work. The three crises are: Infrastructure, Global Warming, Mortgage/Financial Markets Calamity.
FISCALLY RESPONSIBLE, OR
INGREDIENTS FOR AN ECONOMIC KATRINA?
By William R. Neil
It is a commonplace notion of southern coastal waters that some of the most beautiful weather occurs just before the hurricane arrives. That was true even before our era of “inconvenient truths” about global warming announced that the coming storms would be more powerful. Add in traditional American optimism, never more in sunny “morning in America” mode than when talking about the “state of the economy,” blending upbeat salesmanship with the power of positive thinking to push beneath the surface any unpleasant signs. So it was in the 1920’s, where few saw Black Thursday, October 24th, 1929 coming, and so it was in the late 1990’s, where the great plunge of 2000-2002 was missed by 99.9% of Wall Street analysts.
And so it is in the early winter of 2007, where unemployment is low, inflation tamed, and the deep, warm water pools of debt underlying our economic ocean seem as far away as an August tropical wave just surfacing off the west coast of Africa. An upbeat summary in the Washington Post had only one cautionary note for 2007: economy subject to external shocks. It’s a very important observation, but it didn’t say why a sound economy should have to worry so much about such shocks. And that’s the rub: our economy is like a trailer park in it’s vulnerability to heavy weather. America’s middle class, who ought to feel secure, senses that something isn’t structurally sound. They were not buying the Administration’s rosy line all through the fall of 2006, bothered instead by rising medical premiums, college tuition bills, housing costs, and of greater long-term significance, rising levels of personal debt. Their bothers are real, but they don’t get at the underlying currents of a potentially very dangerous situation.
While much public worry has been devoted to the federal budget deficit, its handling by Republicans since the Reagan ascension in 1980 has raised economic cynicism to new levels. When they were in the White House, money was shoveled out the doors through massive “regressive” tax cuts, shored up only by the now discredited “supply side” theories that claimed the cuts would pay for themselves – which they haven’t: not in the 1980’s, not in the early 21st century. When Democrats were in the White House, the deficits were, in Republican thinking, nearly crimes against humanity (as were tax increases, which still are), requiring Constitutional Amendment remedies. But now, according to the V.P., they don’t matter – or they are a good rationale to cut Medicare and Social Security. In one sense, he’s right: they shouldn’t be elevated to an ultimate concern, and they shouldn’t be placed ahead of universal health care, a comprehensive energy/global warming correction strategy and suitable long term investments that will increase American productivity. However, he’s wrong because they are a long term structural worry when run at 2003-2004 levels, and they can reduce policy maneuver room when we really need it, in economic emergencies.
What should be of far greater worry are the massive and growing levels of our trade deficit, personal and corporate debt. The greatest structural worry in the larger economic picture is that the United States is running on debt in too many important sectors simultaneously, any one of which alone would be enough to cause worries. Our great trade deficit was supposed to shrink when our federal budget deficit disappeared at the end of the Clinton era. But instead, confounding “theory,” it only kept on growing. As we increase our lead as the world’s greatest debtor nation, whose currency is still the accepted major reserve currency, the risk grows that at some “light switch” economic moment, our currency will be dumped for Euro’s or some other combination in major exchanges around the world. And, at some point, the dollar will have to shrink in value to correct such a vast imbalance, and that means economic pain for our citizens. If that was all that was out of kilter, it would be difficult enough. But we face more layers of complexity.
The great tech bubble collapse and stock market contraction of 2000-2002 led to an international situation so grave it was called by one economist the greatest crisis since the Great Depression. It threw open the entire economic toolkit of remedies in response: massive federal spending, massive (and misaligned) tax cuts, interest rates pushed in thirteen successive cuts to near zero, and a tremendous storm surge in creative debt financing, including some of the most worrisome in the mortgage loan sector. Credit is due, however: the creation of the housing boom (some, like economist Dean Baker, have called it another bubble) was an act of near financial genius to replace a good part of the 7-8 trillion dollars lost in the stock market collapse with an expansion of home ownership. However, the price of forestalling further collapse was massive debt and speculation - and a national saving rate that continues to go south from 7.4% of national income in 1980, to 4.5% in 1990, to a negative number by 2005. But that’s not all.
In response to the international market turbulence of the late 1990’s caused by the great speculative pool of trillions of dollars sloshing around searching for the daily edge – financial institutions created instruments to “hedge” against uncertainty in these markets as well as to offset the liquidity crises created by the great stock market plunge. Thus debt and its handling became the crucible of financial creativity – and even greater risk. Hence the rise of Collateral Debt Obligations (CDO’s) and Credit Default Swaps (CDS’s) – the complex tools the hedge funds use themselves. Now the great new problem is that these instruments, initially designed to spread and reduce the risks and uncertainties in the new international economy, and the added risks posed by our growing level of debt - have themselves become massively leveraged speculative instruments – with the grand question being whether they have reduced or increased overall economic risk. The fact that some notable firms have not been able to cover their bets, like Long-Term Capital Management in 1998 and Delphi in October of 2005, gives cause for alarm. But the fact that the overall system is growing more complex – bets upon bets upon bets - on the future direction of interest rates, currency trends, level of corporate indebtedness and bond market directions – means that if many of the bets go wrong in the same direction simultaneously, the players may not have enough money to pay off the underlying obligations that this edifice has been built upon. And two successive Chairmen of the Federal Reserve have ruled out regulation equivalent to what we require of mutual funds, which now seem in comparison like the Rock of Gibraltar in terms of transparency and simplicity – which they are not, of course, as 2000-2003 showed.
For example, Delphi, the auto parts supplier, had some two billion dollars in debt issued through conventional corporate bonds, but when that amount was processed through a whole range of derivative instruments, the total obligations after bankruptcy were between $25-28 billion. The Financial Times reported that tens of thousands of separate deals were involved because Delphi was serving as a type of debt holding “reference point”; but obviously, there was not enough to pay off all the debt holders in the bonds themselves. When Warren Buffett, who has used nearly apocalyptical language to describe the dangers of derivatives, had his Berkshire Hathaway firm move to close out the derivatives “book” on General RE, which it bought in 1998, there were 14,384 contracts outstanding and 672 counterparties.
So when we say the new financial architecture is like “bets upon bets upon bets,” blowing Delphi up from just $2 billion to $25 billion in obligations in just one instance - what does this mean for the whole casino? According to some estimates, the total notional value of all the over-the-counter derivatives world-wide in June of 2005 was 270 trillion dollars, far exceeding the world’s GNP. And it is growing rapidly. While defenders of these developments, like the Dallas Federal Reserve Bank point out that the notional value overstates the “actual exposure,” our two examples indicate the problems of both measuring the actual magnitude of exposure and the basic job of recording who owes what to whom. There are open worries that in a serious “storm event,” the system may actually “seize,” because the interlacing network is too complex for anyone to unravel on the spot. Henry C.K. Liu, who heads a NY-based private investment group and writes extensively on economics for the Asia Times, explains that “notional values are not the amount at risk, only the amount on which risk is calculated.” Yet he points out that given the hundreds of trillions involved in the “notional value” of our speculative markets, even a shift of value of 1% in an unexpected direction could cause losses in the trillions – which will far exceed the capital hedge funds have backing them.
In an April 28, 1999 letter to then Speaker of the House J. Dennis Hastert, Robert Rubin, Alan Greenspan, Arthur Levitt and Brooksley Born, the leaders of the President’s Working Group on Financial Markets, Hedge Fund Leverage, and the Lessons of Long-Term Capital Management came right to the point:
The principal policy issue arising out of the events surrounding the near collapse of LTCM is how to constrain excessive leverage. By increasing the chance that problems at one financial institution could be transmitted to other institutions, excessive leverage can increase the likelihood of a general breakdown in the functioning of financial markets. This issue is not limited to top hedge funds; other financial institutions are often larger and more highly leveraged than hedge funds.
In the winter of 2007 worries about the degree hedge funds are leveraged and their interactions with major banks and securities firms, which also may be highly leveraged, are increasing. When Long-Term Capital Management (LTCM) unraveled, its leverage ratio of obligations to capital was 25:1 – some say 33:1. Despite the above 1999 “on target” worries of some of the best financial minds we have, the system is apparently increasing leverage. The online commentary contains accounts, off the record, of worried financial officers speaking of leverage approaching 50-1 in extreme cases. Adding to the concern is that since the late 1990’s, banking has become more concentrated, with the 10 largest holding half of all banking assets compared to just a third in 1990. At the end of 1998, the President’s Working Group …Report told us that the five largest commercial bank holding companies were leveraged at nearly 14-1, and the five largest investment banks at 27-1. It did comment that banks usually have access to financial assistance not available to hedge funds.
The general trend of the 1980’s and 1990’s, summarized by Marc C. Taylor in his book Confidence Games, thus continues unabated:
…new financial products made possible by computers and networks vastly increased the opportunity for leverage and thereby created a collateral crisis. More and more money was being borrowed on the same collateral base. In addition to this, the nature of collateral changed in ways that allowed investors to use securities and derivatives as collateral for additional loans, which in turn were used for yet further investments. This led to faster growth in the financial sector than in the real economy and therefore to a shrinkage of the latter relative to the former. The result of these developments was an inverted pyramiding process in which the foundation of financial markets was virtually disappearing.
Kevin Phillips, astute as usual in his uncovering of the politics buried beneath the economic trends, sees the difference between the economic “rescue” of 2000-2002 and the New Deal of the 1930’s: “No longer would Washington concentrate stimulus on wages or public-works employment.”
Beyond the worries of four major US debt levels and the new international debt “architecture,” economics itself seems like a church without a coherent theology, having passed through, since just 1971: Keynesism, Moneterism/Friedmanism, Supply Side-Lafferism, and Rational Expectationism…coming to reside in the early 21st century in a “low wage, highly leveraged debt/endless liquidity” edifice that leaves many observers, including a number of residents, very worried about its ability to withstand adverse economic weather. Its theoretical struggles are nowhere more apparent than with its difficulty in predicting interest rate behavior, especially the gap between short and long term rates. Interest rate movements, always important to economists, have now become an obsession, and some of that stems from their role in the speculative markets. Mr. Liu points out that in 2005, “86% of the notional amount of derivatives positions consist of interest rate contracts.” There is also growing commentary that the speculative markets, especially hedge funds, can drive interest rates independently of the wished for direction set by the Federal Reserve.
With much of its theoretical basis called into question, the practice of economics now seems to rest more upon its “Emergency Room” skills after a tornado has struck rather than its preventative long range weather forecasting. It has been living off its reputation of repeated, skillful, high-wire rescue operations in heading off major international panics and depressions. But the four corners of US indebtedness are unprecedented, and are no vacation destination, even as the global economy we look out upon has major storm potential stemming from “events” in the Middle East, in the short-term investment and currency speculative markets, and the growing uncertainty from Global Warming generated “extreme weather events.”
Although this brief alert has tried to refrain from tossing out too many numbers, several used by Kevin Phillips in his book American Theocracy (Debt Section) are eye catching. His cites total “credit market debt” – made up of government, business, financial and household components – as having hit 287% of GNP in the late 1920’s – only to surge even higher until in 2004 it reached 304% of GNP – tsunami proportions?
The more one reads about the rise of hedge funds and the exotic debt instruments they rely upon, the derivatives, and the uncertainty about their workings and their transparency problems, the more one is drawn to think of them as comparable to the problem that the melting of ice at the Poles poses to existing climate models. None of these models has factored in the unanticipated speed of their melting and its implications for sea level rise, even as more and more Americans live near the coast. The climate models, which have been “head-on” correct in predicting existing levels of temperature rise due to man-made increases in greenhouse gases, will have to deal with the unexpected feedback loops just now documenting themselves, like the enormous area of methane-releasing melting tundra in western Siberia. Off the record, some of our best scientists feel we are underestimating the rate and impacts of Global Warming even with our current reports, like the 4th IPCC report.
And so it is with the great four cornered American debt structure. We’ve never seen anything like it before – not on all four legs simultaneously. Like the great pools of very warm – and warming - ocean water that can turn an ordinary hurricane like early Katrina into a monster Category Five storm within 48 hours, our debt structures increase the risk that the usual “tropical” wave from an external international economic or geo-political “event” can now supercharge itself and go roiling through our shaky economic structure with a power it is none too pleasant to contemplate. We owe it to ourselves, as citizens, to look and read further.
P.S. Although the focus of this brief essay has been upon debt and the new speculative debt instruments, the much-discussed increase in inequality since 1980 goes hand-in-hand with the “financialization” of the American economy. And with great economic inequality goes political “lack of standing” – the inability of ordinary citizens, and dare we say, unions, to have equal standing with major economic actors in the inner workings of Congress and at the trade negotiating tables. The rise of hedge funds drives the point home even further. By practice and financial threshold to play, they have always excluded the average investor – which was not unprecedented (witness the IPO’s of the 1990’s). That might have been ok had they remained simply tools to spread and “hedge” financial risk. But they and their derivative tools have grown into such a financial “octopus” that they account for between 25 to 50 percent of the trading volume on the New York and London stock exchanges. They have too much leverage and too little collateral. And our more mundane financial institutions, like pension funds and insurance companies, and of course, the banks we have cited above, have had a growing interaction with them. These realities are putting more and more pressure on our political institutions to bring them under the same scrutiny and limits we place upon mutual funds. Given their role in the economic system, hedge funds are no longer just a private club for sophisticated players. Their risks and their mistakes can shake world markets.
WHAT YOU CAN DO: Probably the best short run step to take is to call your Congressional Representative and Senator and ask them to support regulation of hedge funds and derivatives. They need full transparency, higher capital/margin requirements, and limits on their ability to leverage. And to back the efforts of the Apollo Alliance (www.apolloalliance.org), working for alternative energy sources, research funding and all aspects of greater efficiency in the use of energy – like those followed over the past twenty years by California. Working in Apollo’s direction addresses many (but not all) of the economic missteps our nation has followed since 1980.
Kevin Phillips: American Theocracy (Viking, 2006). The last third of the book is entitled “Borrowed Prosperity” and it’s all about debt. He was mid-wife to the Republican ascendancy – now he turns away in horror from what he helped deliver. I believe Phillips is an honest man. He also lives in Connecticut, so when he has drinks with friends, he hears the gritty about the latest Wall Street gambits.
Marc C. Taylor: Confidence Games (Univ. of Chicago, 2004). This is a remarkable book cutting across many interdisciplinary lines. But at its heart are the parallels between the virtual world of cyberspace and the new financial architecture of debt, with the Faustian dream of quants becoming “gods who seemed to allow traders to realize the ancient dream of creation out of nothing.”
Joseph Stiglitz: The Roaring Nineties (W.W. Norton & Comp., 2003). This Nobel Prize winning economist was an insider at the Clinton White House and the World Bank, now turned outsider. And you thought you knew what went on in the ‘90’s economy?
Richard Parker: John Kenneth Galbraith (Farrar, Straus and Giroux, 2005). If you want your economic history through a compelling biography, this is your book. Galbraith was right: politics is always deeply woven into economic assumptions.
John Gray: False Dawn (The New Press, 1998). Think you’re getting the lowdown on “globalization” by reading Tom Friedman? Think again. Gray sees the Utopian thinking in the global celebrators like Friedman, a “new Market Man” from the Right to match the old “New Soviet Man” of the 1920’s.
William Greider: One World, Ready or Not (Simon & Schuster, 1997). Washington insiders won’t recommend this book, or the author, but the Univ. of Chicago puts it on the reading list next to Adam Smith, Marx, Weber, Durkheim, Schumpeter….in a core undergraduate course on society and economics. That should tell you something.
Joseph Romm: Hell and High Water (William Morrow, 2007). With our metaphors grounded in global warming and hurricanes, the latest book puts the dangers and political ramifications right in the title.
Economic Policy Institute Web Site: www.sharedprosperity.org Jeff Faux’s article of 1/11/07, “Globalization That Works for Working Americans,” can be found here. This is the progressive side of the economic ledger, done in part to answer Robert Rubin’s “Hamilton Project.”
Wharton School of Finance, U of Penn: http://knowledge.wharton.upenn.edu . I went here for help, to a famous Business School, with no left-of-center slant that I’ve ever heard of, to test the worries of authors like Kevin Phillips about hedge funds and derivatives. Free sign up and then pop those topics in and see the warning flags from even the industry commentators themselves. If you’ll forgive the expression, many seem to “hedge their bets” on the long term stability of what has unfolded in the past ten years. If you want very contemporary relevance, see Jenny Anderson’s NY Times story “S.E.C. is Looking at Stock Trading (Feb. 6th, 2007), ( www.nytimes.com/2007/02/06/business/06wall.htm)
Presidents Working Group on Financial Markets, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (LTCM). (www.ustreas.gov/press/releases/reports/hedgfund.pdf). The financial establishment’s report on what happened and why. Even they worry about hedge funds registered offshore in unregulated banking havens, clouding the legal waters as to whose bankruptcy laws apply when they are about to go under, as well as to what other accepted banking standards may or may not apply.
Randall Dodd, Derivatives Study Center (www.financialpolicy.org). Yes, that’s right, a “Derivatives Study Center,” right here in DC, founded out of some of the same worries that are conveyed in this essay.
Henry C.K. Liu: Greenspan: The Wizard of Bubbleland. You can find Mr. Liu’s four part series on the problems in financial markets and the global economy at his website: www.henryckliu.com. I thought his explanations of notional value and how the “repo” markets work were some of the clearest I came across – in matters that are notoriously opaque to the public. If you ever wondered how major speculators manage to do it all without much – or none - of their own money – then look into the term “repo” markets.
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