Who let the Sharks Out?

As the economy continues its slide towards recession, we now have a pork-laden rescue of many of the folks both responsible for the recession as well as the crisis.  TARP may unfreeze the credit markets, but until we responsibly regulate the financial markets that are now shoveling troubled assets onto taxpayers and until we support the prices of their underlying assets (that would be folks’ homes), we will not solve the problem.

I focused recently on the lax lending standards that helped to create the housing bubble (fueled also by the Fed who kept interest rates too low, too long after 2001).  It was the red meat thrown into the piranha pool.  Let’s talk about what the piranhas did with the red meat once they had it. 

Let me mention first that we’ve nearly been here before when Long-Term Capital Management (LTCM) came close to collapse in September 1998 at the time when Russia had difficult repaying its debt. The Fed rescued the fund and showed that some guys are  just “too-big-to-fail”. The Fed wanted to stop possible contagion coming from the failure from spreading to commercial banks.  Studies at the time showed that losses to investment banks during this type of contagion could be huge  (including one done by my Financial Intermediaries Seminar prof).  They noticed that investment banks would be far more vulnerable to losses than depository institutes. This small crisis that most folks probably don’t even remember was the canary in the coal mine. 

Meanwhile, the primary mortgage market was coming under the spell of the underwrite-nearly-everything mentality spurred on by Fannie and Freddie. We’ve mentioned that Fannie and Freddie also imply a government guarantee.  Now, we have a situation where the Fed has shown its readiness to put the tax payer’s money behind anything it deems too big to fail. Both actions were like chumming the waters.  Rising house prices were just more blood on the water. It was only time before the piranhas and sharks came to feed.  They were being encouraged to ignore risk and that’s not a wise thing to do.

Five investment banks, including Goldman Sachs, approached the SEC with a proposal around 2004.  They sought an exemption for their brokerage units from old depression-era regulations that limited the amount of debt they could incur.  An exemption from this leverage rule would free up a heckuva lot of money to invest in some new-fangled investments:  mortgage-backed securities, credit derivatives, and credit default swaps.  They got permission. Enter the net capital rule that enabled the piranhas and the sharks.  During the next few years, leverage ratios increased until for about every dollars worth of equity held by an investment bank, there was around $30 in debt.

Credit default swaps act like insurance.  They are instruments intended to cover losses to banks and bondholders when companies fail to pay their debts.  Since 2000, the market has boomed from about $900 billion to more than $45.5 trillion.  This about twice the size of the entire U.S. stock market.  The market for credit default swaps as well as the market for mortgage securities were left unregulated.  Many folks have been worried about this market for some time.

The Comptroller of the Currency, a federal bank regulator warned that increased trade in swaps during 2007 was putting a strain on processing systems that were used to handle swaps.  Swaps are essentially what brought down AIG.  Back in the beginning of the year, AIG found that it had incorrectly valued some of the swaps and announced that mistake would cause the company to lose $6.3 billion more than they had estimated before.

Placing correct values on Swaps and Mortgage securities is very difficult.   Big banks, insurance companies and hedge funds are among the financial institutions that trade these derivatives.  CDS tend to be private agreements where buyers of the protection/insurance agrees to pay a premium to the seller over time.  (Much like an insurance policy premium).  The seller pays only if a particular crisis occurs.  These contracts can also be bought and sold.  Because the market is basically unregulated, no one quite knows when the swaps are sold and to whom they are sold.  This can be a problem when the protection is required, say like when the Hurricane Katrina of asset bubbles bursts in the housing market.  Just so you know, the largest players in this market are JP Morgan Chase, Citibank, and Bank of American.  All WAY too big to fail, right?

Enter speculators as this market gets large.  Speculators (read HEDGE FUNDS) have used these instruments to bet on a company or a bank’s failure. Funny thing is there is actually more value now out there in the derivatives than there is in the underlying assets.  Remember, this is BEFORE the bubble bursts and brings the asset prices down even further. So credit default swaps are basically default insurance, although they can’t be named that.  So what happens when every one needs to make a claim on their insurance and can’t exactly locate your contract and it probably resides with some one who is in worse shape than you?  (Ah, let your imaginations run away with you, it’s bad.)

So, let’s get back to our Pirahanas and Sharks.  They’re being encouraged to loosen up those lending standards by Fannie and Freddie AND they can buy insurance too if their bad loans go bad.  How can you lose with a deal like that?  It doesn’t appear that you can, does it?  So what do you do?  Continue underwriting loans for folks without income, folks without credit, folks that are even dead. (Yes, dead, I’m not making that up.)

I think you can see that what we have here is the perfect storm.  So let me get back to what this bill doesn’t do.  It DOESN’T stop the assets from continuing to go bad, at least in the housing end of things.  It DOESN’T regulate any of the players in this market although the investment banks are now under the jurisdictions of bank holding companies and basically the FED.  It DOESN’T deal with the leverage issue.  It DOESN’T punish any one for lending bad loans even.  No one is getting yelled at for encouraging this — not Fannie and Freddie, not the FED and not the SEC.  Definitely not the congresscritters that enabled them either, at least not yet.

What we are witnessing is the creation of more TOO BIG TO FAIL critters AND we’re giving them more money to lend out and we have inadequate regulation.  It’s time to take the chum out of the water, folks!