It's been a while since I've put up a good financial rant, but today deserves one, because these are special times. I have a superb deal for you:
- You give me $700 billion in cash.
- I will give you $700 billion in bad mortgage bonds, toxic derivative products, and whatever fertilizer I happen to have in my garage right now.
Foo - I'm too late. Uncle Sam is already signing you up for that deal.
Asymmetric Risk
At the core of the entire financial disaster is asymmetric risk. Any time you have a situation where the party who takes a loss is different from the party who takes the gain, the party that takes the gain is going to try their hardest to make the transaction happen. This asymmetric situation is everywhere:
- A home buyer who is not required to make a down-payment (zero percent equity) gets the up-side of a rise in housing price, but transfers the down-side risk to the bank.
- A mortgage broker that makes a commission on a mortgage but doesn't hold the mortgage makes money on the deal but doesn't get penalized if the mortgage goes into default.
- A bank that has FDIC insurance, but does not have to back up its risky investments with capital holdings gets the up-side of the risky investments but gets bailed out for the down-side. (See below.)
Fundamentally what we have is a situation where risk has been transferred (often using derivatives) from the party making a profit to a party that has insurance (whether real or implied) from Uncle Sam.
Grass Fires
Derivatives are the vehicle that makes this possible. Basically a derivative is a contract that obligates parties to perform a financial transaction (one that will usually be really bad for one party) but does not require the party at risk to hold any money in reserve.
In the good old days, your bank took deposits from working people, loaned money out in mortgages to home owners, and kept the interest rate difference as profit. Now since working people always want their money bank but home owners sometimes default, the bank had to keep a little bit of deposit money aside (its reserves) just in case; the size of that reserve has to be proportional to the risk of the home owners failing to make their mortgage payments.
Derivatives have no such capital holding requirements. To see how insane this is, let's look at a "credit default swap" (CDS) - one of the most ludicrous inventions ever. A CDS is basically insurance on a bankruptcy. Here's how it works:
- You have $100 in General Motors bonds and are a little bit worried that GM might go under.
- I have $100 in treasury bills.
- We enter the following contractual agreement: in the event that GM does go broke, I will swap my treasury bills for your (now quite worthless) GM bonds.
- You will pay me some money right now to take this idiotic deal.
So basically what we have is bond insurance - you pay me a small premium, and in the rare event of a default, I insure you. Now here's the rub:
I don't have to keep the treasury bills locked away!!! Heck, I don't even have to keep a
fraction of them locked away. I can go spend them on beer and pray that GM doesn't go broke.
Of course, this has some unfortunate effects. Perhaps your GM bonds had a low rating because GM is in deep doo-doo. But if you buy some insurance from me, you can "enhance" the credit of the bonds...GM bonds + insurance are a lot nicer than GM bonds. But what happens if I, the writer of the insurance, go broke? Your GM bonds instantly turn back into a pumpkin, so to speak. At that instant, any other deals that made sense only if GM bonds are good is now quite screwed up.
And this is the nature of counter-party risk. If you enter into a derivative contract and you need that contract to be valid for your business, you take on the risk of the other side of the contract going broke.
The experts told us that derivatives would spread risk and make the system more robust. They were half right - derivatives definitely spread risk. Derivatives on risk is like on a grass fire.
Selling Uncle Sam
Now we can start to see why Uncle Sam is considering spending $700 billion dollars to buy a huge pile of toxic waste. If you have counter-party risk, it becomes in your interest to keep the other party alive. Uncle Sam's umbrella of protection has been wrenched out from over the small depositor and home owner and extended to wall street through the mechanism of derivatives.
John Hussman has a great explanation of how you can hook Uncle Sam into insuring things that the tax payers really should not be insuring:
First, suppose that Citibank gets money from its depositors at a floating rate, and lends to mortgage borrowers at a fixed 6%. Now GM issues bonds yielding 7%, and enters a swap with Citibank, in which Citibank pays GM 5% fixed in return for floating. (Specifically, both parties agree on some notional principal, say $100 million, and each makes payments to the other, determined by multiplying a fixed or floating interest rate by that principal amount. The market for this sort of transaction is huge).
Well, now GM is paying an actual interest rate of floating + 2% (pay 7% to bondholders, get 5% from Citibank, pay Citibank floating). Meanwhile, as compensation for the credit risk it has accepted all around, Citibank earns a fixed 1% margin regardless of interest rate movements (pay depositors floating, get 6% from mortgages, pay 5% to GM, get floating from GM). Neat. And since Citibank is federally insured at the depositor level, and “too big to fail” at the institutional level, Uncle Sam is now a counterparty that effectively shares the risk in the case that GM or homeowners default. Similar transactions serve to swap risky corporate and mortgage borrowing into safe government agency paper issued by Fannie Mae and Freddie Mac.
The financial alchemy is in Citibank exposing itself to risk (and making money by doing so) without reserves. Remember the good old days? Well, in this transaction Citibank didn't put any money inside to cover the case where GM goes under. (If GM goes under, Citibank is left writing mortgages at fixed rates while paying depositors a floating rate. If interest rates go up, Citibank will lose money with every transaction. But Citibank has no "nest egg" of cash stashed away to cover this case.)
Simply put, if you can get Uncle Sam to be counter-party to another entity, Uncle Sam has to protect the other entity. And thus here we are, trying to bail out all of Wall Street.
Extending the Umbrella
Let's go back even further - how did we get here? We have a policy in this country (the "American Dream") of subsidizing home ownership in the form of tax breaks and credit enhancement. Basically Uncle Sam is willing to spend money to get you to buy a home by:
- Providing tax breaks for mortgage interest (which creates an incentive to borrow money, not save, and makes financing of houses effectively cheaper).
- Keeping interest rates low, which also makes financing cheaper.*
- Providing credit enhancement to borrowers (that is, guaranteeing mortgages).
To this last point, the Government does this both by writing guaranteed mortgages (FHA, etc.) and also by creating Fanny Mae and Freddie Mac - two companies that write mortgages. Fanny and Freddie make mortgages cheaper by using their good credit rating to get cheap financing for home buyers. Why would Fanny and Freddie have a good credit rating if their job is to make housing a little bit too easy to get? Simple: we all assumed that the government would bail them out if things got ugly. And of course, that is exactly what happened. As a net transaction, Fanny and Freddie represent Uncle Sam backing up a huge number of home buyers on their mortgage.
So we have the government providing credit enhancement. How can Wall Street profit off of this? Simple: they need two things:
- They need a lot of people to buy homes and utilize that credit enhancement, so that it can then be transferred.
- Wall street then needs to find a way to transfer that credit enhancement from the individuals doing the borrowing to other parties, who will pay a fee for this.
Getting people to utilize the credit enhancement is pretty easy: offer them cheap financing. Offer them all the up-side of a market increase without the down-side by writing nothing-down mortgages.
You then write products that are tied to this sea of government-backed paper and you pull in Uncle Sam as a counter-party. You sell this off with the wink-and-a-nod that the products are credit enhanced because you-know-who is a counter-party. The huge chain of derivatives and "engineered" financial products spreads the risk all over the place, and thus spreads Uncle Sam's umbrella all over the place.
If Uncle Sam walks away and lets Wall Street go down, the chain of derivatives guarantees it hurts "main street", the little guy, for whom cheap housing was invented. This is the true price of subsidized housing.
Only Pain Will Heal
Besides a huge credit mess, what we have is overproduction: too many houses and too many mortgage bonds. The only way out is to stop making houses and mortgage bonds for a while. And this is where I have the greatest fear; falling prices for houses and mortgage bonds is the market's way of dealing with the extra product floating around.
If the Government starts spending hundreds of billions of dollars to prop either, that is money spent on an inefficient and overproduced part of the economy, destroying real investment in future US growth. But I fear that the debate in Washington is on who gets the bail-out, not whether there should be a bailout.
* I know, there is an immense amount of hand-waving in that statement and it isn't really supportable. In fact, this whole rant scrambles cause and effect pretty thoroughly. But I must point out that this is the nature of asymmetric risk; parties may not have known Uncle Sam would bail them out, but they didn't have to care, since they were in a position to make all the profit and take none of the pain.
