As we progress through this recession, the media talks about a lot of things: foreclosures, CMBS, lack of credit availability, the price of a barrel of oil, the price of gold, yield spreads, the DOW, the S&P.
CNBC did a superb job explaining how and why the residential real estate market overheated and subsequently collapsed.
Congress passed the TARP, bailed out Freddie Mac and Fannie Mae, AIG, Citibank, and numerous others. The Obama administration pushed through a stimulus package, and the Fed has expanded its balance sheet to record levels.
Yet few people are explaining to the American Public that our banking system is insolvent and why that system is insolvent (the 800 pound gorilla). The residential market collapse was bad enough, but given the amounts of money the U.S. Government has printed in the face of this financial crisis, its not that big a problem. In fact, prior to last September, all the bad residential mortgages could have been paid or guaranteed with $500BB. Don't get me wrong, that's a huge number, but nowhere near as large as the trillions of dollars being thrown at this recession. The question is: if the bad mortgages totaled $500BB, then why is the problem trillions of dollars large? Why is the banking system insolvent?
The credit derivatives written on mortgage backed securities may very well destroy the Capitalist system the United States was built upon. Let me explain, if I owned a mortgage backed security, or a piece of a mortgage backed security, I could hedge my risk by buying insurance from the investment banks on my mortgage backed security. This was good for me and good for the bank selling the insurance. This insurance is called a credit derivative and is good for the insurer because they can generate a revenue stream without putting out any cash, and as I explained in an earlier blog represents an infinite return. The investment banks decided this was a great thing, and hey since all these securities had AAA ratings they had to be safe, right? What the Investment banks did next is criminal. They sold multiple insurance policies per security. In other words they took bets that the securities would not fail. While the purchasers of those derivatives were in turn betting those securities would fail. Looks like the investment banks were wrong. For the life of me, I can't figure out how - they had risk models based on quantum physics. The fact that someone earning $40,000 per year was buying a $400,000 asset on credit failed to sound an alarm.
If I insure your $100.00 security once, my liability is $100.00 If I insure it 50 times my liability is $5000.00. I used a multiplier of 50 because that's the leverage ratio carried by some of the investment banks before they merged, or became regulated banks. With a leverage ratio of 50, what was a $500BB problem has become a $25 Trillion dollar problem. That's why the U.S. Government has not bought the Troubled Assets. They aren't assets. They are liabilities on steroids and would break the US Government if they were purchased by the Government. This is also why the credit market is locked up. The banking system is insolvent, and hopelessly under capitalized.
So how does the Government solve this problem? The solution to bank insolvency due to credit derivatives is possible on either end of the problem. On the originating end, the Government simply has to guarantee securitized mortgages. On the other end, a more complicated solution is Nationalizing the banks, taking them through a bankruptcy process, wiping out the shareholders, the debt holders, and most importantly the derivative holders. Any other solution drags down the U.S. Economy for as long as a generation. Yet, neither solution is under consideration. Instead, the solution seems to be a slow bleeding of the U.S Treasury.
The question is why? Who benefits from this solution? Who owns these derivatives and why are we protecting them? I'm a Keynesian, so I really don't have a problem with the Government stepping in when necessary to stabilize the system. In this case, I do have a problem with the solution, or lack of solution. Tax dollars are flowing to derivative holders, and in turn those derivative holders are waiting for the system to collapse with dollars that increase in value in a deflationary environment to buy up the assets. In a Capitalist environment, they should be considered shrewd investors taking advantage of an opportunity. The problem with that scenario is that the derivative market was never open to the public. Most of the readers of this column, including me, never had access to these investments. The derivatives were available to a select group of individuals only and were never publicly traded. This group now exclusively benefits from U.S. Taxpayer dollars.
The chosen solution seems to be transferring wealth from the Treasury to the derivative holders, through the banking system, while simultaneously stimulating the economy with demand side policies. In closing, I repeat my question: Why don't we acknowledge the 800 pound gorilla? What is the end game and why have our leaders chosen a solution that benefits a select few to the detriment of a vast majority of others?
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