To the Brink: The Greatest Financial Crisis Since the Great Depression

April 5, 2008

Dear Citizens and Elected Officials:

It has been some time since I have commented directly on the economic crisis, although the final section of my essay A Citizen’s Guide to the Missing Green Rail Vision for the MD/Metro DC Region, entitled “Where Three Crises Meet,” noted that the “frame” for media discussion has shifted towards viewing what is unfolding as “the greatest financial crisis since the 1930’s” (Emailed in mid-January, 2008), a far cry from the very narrow focus on the sub-prime mortgage alarms of August. As each month has gone by, the crisis “containment” boundary has been shifted to encompass more and more of our various financial markets. All this has been happening before the job losses have really started in earnest, just beginning now with Friday’s announcement (April 4th). Such losses will apply pressure to new sets of debt derivatives, mainly credit cards and auto loans, which have been “securitized” like mortgage debt. It has been my belief that some of the seeming psychological pressure to avoid recognizing a recession stems from the knowledge/fear of what it means for financial markets that cannot cope with just the housing/mortgage distress, bad as that is. Some prominent conservatives - I’m thinking of Larry Kudlow on CNBC - have turned optimism/free markets/no recession into a rigid catechism which regulars are required to recite. It’s also hard to miss Larry’s Patton pose in front of the huge American flag, arms folded – whew – I don’t want to disagree with him. That’s the secular conservative version of the old Baltimore Catechism recital from parochial school days. If you want to try hot-button heresy on a free market ideologue, just try suggesting “public infrastructure jobs” as part of your stimulus package. Then duck and keep a handkerchief handy. But if private financial markets can’t function with unemployment levels at just 5.1%, what will they do at 7-9%? And I acknowledge here that I have about as much “faith” in official unemployment figures as Kevin Phillips does in official inflation rates (see his post address below).

So I wanted to share with you now a brief analysis I’ve prepared on the financial reforms put forward by Secretary of the Treasury Henry Paulson, specifically their Executive Summary as printed in the New York Times last week. Of course it draws upon my sense of the precarious and ominous state of the economy, from my essay Ingredients for an Economic Katrina, which was written in February of 2007, before the first overt signs of market distress had surfaced, and which I shared with you in August. I am working on a longer piece to try to make sense out of the deepening crisis and hope to have that done in a couple of weeks. If you would like a copy of either of these two earlier essays, just drop me a note a w.neil@att.net [1]. I’ve pulled the last chapter of Green Rail Vision out as a stand alone document called “Where Three Crises Meet,” so you can get it that way too.

For now, I have the following observations:

Our financial system nearly crashed, literally, on two occasions over the past three months, back-stopped only by the dramatic and unprecedented Federal Reserve intervention before markets opened on the morning of January 22nd, when the Dow Jones Futures’ markets were set to open 500 points down and after Asian markets had dramatically sold off on Monday, January 21; and then the complex and still-being-explained Fed actions surrounding the acquisition of collapsing investment bank Bear Stearns by JP Morgan Chase Bank over the weekend of March 15-16th, designed again to head off panic before the Asian Markets opened Monday morning on March 17th.

So do we know what really happened with the Bear Stearns event? No we don’t. It was a run on the bank, an investment bank, to be sure, but there were no lines of citizens in the street as there were in Sept. of 2007 when Northern Bank in England went under. That’s because the run against Bear Stearns emerged from within the deep shadows of the “new financial architecture,” much of it unregulated, and like the hedge funds themselves, set up primarily for a separate class of investors, but with impacts that can maim your 401(k). It happened so fast and so inexplicably that the SEC and the FBI are investigating possible criminal actions in market bets against Bear. But make no mistake about it: a Rubicon has been crossed with the use of public money by the Fed to “rescue” an investment institution where citizens do not currently have the right to the facts that led to the near calamity, and in the broader context where it remains to be seen whether drowning homeowners can also climb into the lifeboat. Please note that the Congressional hearings held this week did not even guarantee that committee investigators would have suitable access to all the information they - and the public - need. And since August, the scope, duration and now legal stretch of Fed actions have been unprecedented. Far from pure free markets, it now looks like markets are rather dependent on government action.

One can object to the action from the right and the left, and on a variety of grounds, but this much I know from my earlier research and writings: there was a very high risk of total market meltdown/freeze without the dramatic action taken, so on this one I’m with the Fed Chairman. But the ongoing pressures in the system remain. And based on what I know now, an “entity” was set up in Delaware (as usual) to anchor the risky remaining debts/assets of Bear (and keep them off JP Morgan’s ledger?), and a private contract has been let for ten years to BlackRock Management to unwind the remaining positions under the best possible terms…which leads us to….the state of other banks…..

In research for my pending article, I was drawn by the commentary on Bear Stearns to the state of the balance sheets of other major banks, especially that of JPMorgan Chase, the partner and beneficiary of the “shotgun” merger of March 15-16th. Because it is a commercial bank, at least in part, the Office of the Comptroller of the Currency (OCC) issues quarterly reports which show the notional value (maximum size of the total bets placed) of the “derivative contracts” they hold. Some of these derivatives are from old, classical instruments, futures and options, but the largest category, “total swaps,” covers the very worrisome “innovative” product called Credit Default Swaps (CDS), which many commentators have cited as the next category of distress after bad mortgage debt. The total value of the derivative positions of JPMorgan Chase are an astounding 91.7 trillion dollars, dwarfing nearest competitor Citibank at “just” $34 trillion. Yes, that’s right, it’s trillion. Billion got left behind by financial “innovation.” I’m sure you are as reassured as I am that the total “assets” behind these derivatives are $1.24 and $1.23 trillion, respectively. We have no similar accounting for the investment banks, which do not report to the OCC, including Lehman Brothers, Goldman Sachs, Morgan Stanley and Merrill Lynch. If you would like to share these worries in greater detail, Martin D. Weiss’s article at the Market Oracle at www.marketoracle.co.uk/Article4043.html [2] from March 17th, can outline the situation for you.

Before you go there you might want to ask yourself: how can the derivative positions of just one bank, $91.7 Trillion dwarf the 2007 GDP of the entire US economy – at about $13.86 trillion? That’s something we’ll try to explain in future writing. Hint: the answer is in leveraging techniques, which enable bets in derivatives to multiply the magnitude of their bets without having to buy assets directly, like you do when you buy ten shares of Google and own the shares outright. Leveraging is also done largely with borrowed money…Defenders will say that JPMorgan’s positions are market neutral so they are balanced against swings in either direction. But so much has gone so wrong in so many credit markets, who knows if this strategy will hold up.

I’m also wondering if you are struck, like I am, by Progressives being behind the curve of the financial crisis, having assumed for far too long that the major issues of our financial system, and the economy in general, have been, in the all-too-smug term of conservative commentator George Will, “settled,” and left in the hands of those closest to “The Street” itself? Well, events in the real world have just unsettled them, throwing open a window for new policies and structures wider than it’s been since 1929-1935.

For example, over at John Podesta’s think tank Center for American Progress, where they’ve been putting on 3-5 monthly events since Nov. of 2003, they haven’t done a single one on “the new financial architecture.” On everything under the progressive sun, but not that. Mortgage crisis yes, but not on the new system I comment on below (and the key terms highlighted.) The same for The New York Review of Books, what some call the “flagship” of the intellectual left. Not even in the wake of August, 2007. Despite a published program for the Take Back America Conference (March 17th-19th, 2008) that runs to 56 pages (art catalog length) sponsored by the Institute for America’s Future, and which is to the left of Podesta’s Center, there was a nary a workshop on our new financial system. Their Email mixture is getting better, and I am starting to see more reporting on the financial world, but if these institutions on the left are supposed to lead the way in explaining our world, no wonder the public is so bewildered about events. And scratching their heads too over the alphabet soup of new financial instruments that has turned sour, a cruel inversion of the nourishing alphabet agencies of the New Deal of the 1930’s. That’s two alphabet legacies we have now, one from the Conservative Era (aided and abetted by the Wall Street Democrats from Carter to the Clinton era) and one from the liberal New Deal of the 1930’s, with March 4, 2008 marking the 75th anniversary of FDR’s inauguration during the worst banking crisis in American history.

I’ll close this section with a couple of reading recommendations. Jeff Faux’s cover story in the April 14th print edition of The Nation is excellent (Is This the Big One? How Arcane Financial Instruments and Unregulated Wall Street Greed Could Plunge Us Into A Depression - and What to Do About It). Robert Kuttner’s new book, The Squandering of America (Alfred A. Knopf, 2007) is good, especially chapters 3-6, on the new financial tools. And he gives you the lowdown on Robert Rubin’s role in much of what has unfolded since the 1990’s. Keep that in mind for our next Democratic President. Robert Rubin will be there, at the table, in some capacity. That’s fine, I want to know what he thinks; we just need to expand the guest list. And, if you’ve been wondering, like I have, what ever happened to Kevin Phillips since his American Theocracy appeared in 2006, the answer is, he has a new book coming out April 15, called Bad Money (Viking) and he gave the announcement on “The Huffington Post” on March 31st billed as “The Destructive Rise of Big Finance” at (http://www.huffingtonpost.com/kevin-phillips/the-destructive-rise-of-b_b... [3]). Kevin Phillips is a national treasure on the economy and I’m eager to see what he has to say since reading the last section of his Theocracy, called “Borrowed Prosperity,” which should have given policy makers a “storm warning” on what has unfolded since August of 2007. Bob Rubin might even have profited, over there at Citibank, had he read it.

I also invite you to visit my own book review of Robert D. Leighninger Jr.’s Long Range Public Investment: The Forgotten Legacy of the New Deal (Univ.of South Carolina Press, 2007), which appears on Amazon.com and is called Still Shining: A Beacon of Hope From the New Deal (at http://www.amazon.com/review/product/1570036632/ref=sr_1_1_cm_cr_acr_img... [4]) I doubt Mr. Leighninger will be appearing on Larry Kudlow’s show anytime soon.

And now,

Commentary on the Proposed Reforms:

Leveraging the Laughs (and Tears) at Treasury

The 18 page Summary of the proposed Financial Reforms released by the United States Treasury Department one day before April Fools day should provide some continuing laughs “going forward,” as they say in policy speak.

Although the term “market stability/instability” appears 35 times, and is the leading repetitive worry phrase, the document does not seem to make the connection between the obvious lack of market stability and the pace of financial product “innovation”, a term which I found 12 times, for second place. It appears they want to grandfather in those innovations and fear that if we don’t continue to load up with even more we will lose out to foreign competitors. For a document so enamored with “innovation,” it’s very curious that “hedge funds” are only mentioned once, as are “derivatives” and “margin,” and the even more crucial word “leverage.” If collateral was in there, I missed it. Same for Collateralized Debt Obligations (CDO’s) and Credit Default Swaps (CDS). And the word “speculation” is missing too. I guess it’s just more polite to subsume them under bigger categories. Not so scary, at any rate.

Now the curious thing about the infrequent mention of these key terms is that hedge funds are increasingly associated with market “volatility,” which certainly has some relation to market instability. And hedge funds are intimately interwoven with investment banks, and we will perhaps some day learn of their role in the unraveling of Bear Stearns. But to have 18 pages on these matters only mention “leverage” once is truly astounding, since it was the front and center word in the initial report of the President’s Working Group on Financial Markets, and mentioned in the report’s cover letter of April 28, 1999 to then Speaker Hastert, a letter signed by Alan Greenspan and Robert Rubin, among others. It stated that “the principle policy issue arising out of…the near collapse of LTCM is how to constrain excessive leverage…” Of course, the report said we should rely upon voluntary “market discipline” to rein in that leverage, in the same way that the Treasury proposals now lean heavily on “self-regulatory organization” powers to curb problem areas. The fact that it wouldn’t be using “market stability” 35 times today if self-regulation had been effective in curbing too much leverage in the spread of bad mortgage CDO’s still has not apparently dawned on the Treasury Department.

Financial markets are in deep trouble today not just because of lax mortgage standards and a bursting housing bubble, but also because derivative “innovations” and hedge funds have spread risk rather than reducing it. And rather than increasing market liquidity, they have frozen markets. Today, we have not only a liquidity crisis but a solvency crisis at some banks. (This was the call by a disciple of Milton Friedman, Anna Schwartz, way back in 12/07: “‘The banks and the hedge funds have not fully acknowledged who is in trouble. That is the critical issue.’” http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/12/23/cccris... [5]) .

Somewhere in all the polite euphemisms and alphabet notation of this report, it loses sight of the basic reality: our financial markets have become distorted by too much speculation in heavily leveraged debt instruments, what it calls “innovation,” but what some other observers like William Gross of PIMCO Bonds simply call “something resembling a pyramid scheme.” The needed reforms will have to be based on very different assumptions than the ones in this report. We might even have to go back to such quaint notions as long-term value investing instead of pure short term speculation as the basic feature – but that probably wouldn’t qualify as “innovation” in this Treasury’s dictionary of terms.

And I’m wondering, if somewhere in the 212 pages of regulatory details, not reviewed here, there might be included a requirement, should they retain their current elevated status, that hedge fund managers and investors be given formal designation as our financial Peerage, and be required to don powdered wigs and robes at their meetings. Our surviving 401(k’s) await a nod from our Eminences.

Join with me now in enjoying the moment, when, just this past week of March 31st, Secretary Paulson was on the road, trying to persuade Chinese financial officials to open their system to some of our recent “innovations.” I kid you not. Talk about timing. Not content with the troubles wrought at home, the Secretary wants to share our secret recipes for financial bliss overseas. And do we ever mean secret – even from our own citizens. Can you imagine the translator’s job of explaining how Collateralized Debt Obligations and Credit Default Swaps work – and not just the plain vanilla versions – the squared and cubed versions as well? Not content with entertaining us at home around April fools day, he’s taken his show on the road. This should supply material for the Daly Show and the Colbert Report for many weeks to come. You have to laugh at this – or you will surely end up crying instead. And what is that Chinese phrase for… “Lock up the family silver?”

Best,

Bill Neil
w.neil@att.net [1]