“Coming soon to a Main St near you,” I could add. One of the things that distinguishes the current financial meltdown from the one that gave rise to the Great Depression is that it’s happening right in the middle of a presidential election. That’s unhelpful because there’s a disconnect between what might be sensible to propose and what might garner votes for either candidate. Luckily John McCain, in a desperate attempt to distance himself from his constant economic position of decades, has been so incoherent that it hasn’t obliterated sensible comment on what’s actually happening.
What we’re witnessing, hopefully, is the meltdown of the political theory that successfully persuaded America for the last 30 years that deregulation is a wonderful thing. It’s as if America has finally discovered that banning the umpires from the football field really doesn’t improve the game of football – it only makes it more dangerous. It may not have escaped your notice that all the currently collapsing financial institutions are American – they were the lobbiers for deregulation, then the beneficiaries of deregulation and finally the victims of deregulation. They’ve sewn the breeze and reaped the whirlwind in almost record time.
The breeze was partly sewn in 1999 with the passage of banking reform laws driven by Phil Gramm – chief economic adviser to the McCain presidential campaign – until he said in July that the current recession was only a “mental recession” and America had become “a nation of whiners.” He was promptly thrown under the campaign bus. Gramm’s reform laws removed the enforced separation between insurance, broking and banking that was put in place by FDR in the 1930s.
Bring Me The Head of Christopher Cox!
Early this week McCain called for the head of Christopher Cox, Head of the SEC (Securities and Exchange Commission), assigning some of the responsibility for the financial crisis to him, and saying that he would have been sacked if McCain has been president. One problem with that proposal is that the President doesn’t have the right to sack the head of the SEC. Another problem is that, while the SEC might have been more stringent with financial institutions that have been collapsing, it really didn’t have the oversight to affect the subprime bubble that lies at the root of this crisis.
In among the organizations that should have been called to account are Moody’s and Standard & Poors, both of which failed dismally to assign realistic risk ratings to the subprime derivatives that pervade the balance sheets of the failing institutions. However you may say that assigning the blame there is a little narrow, because what has happened in these dangerously deregulated times is that a kind of shadow banking system has evolved in America. Typically banks are forced by regulations (that dirty word again) not to over-leverage their lending activities, which ensure that they keep a sane ratio of assets to liabilities. Traders in derivatives are under no such obligation.
What Caused The Crisis?
You may be wondering why the crisis suddenly exploded given that we’ve known about the extent of the subprime mess for many months now. Here’s why:
The subprime chickens didn’t come home to roost all at once. They made their way home gradually. House prices fell gradually reducing what asset coverage they offered and mortgage holders gradually defaulted more frequently. This meant that the holders of subprime derivates were gradually being squeezed – a slow motion train wreck was how one commentator described it.
Bears Stearns was the first of the dominoes to fall, but it was conveniently snapped up by JP Morgan – a “safe” bank. Everyone knew that it wasn’t the end of the story and the banks that were in trouble were (secretly) seeking buyers. The problem was that there was no easy way to actually value the dubious derivatives, so there was no way for anyone that might be tempted to buy Lehman Brothers to know what was a justifiable price.
On Monday the US Government allowed Lehman Brothers to go into Chapter 11. That wasn’t clever. In a shadow banking system where no-one’s quite sure who has got asset coverage for what, that immediately cast a shadow over every other bank – and AIG, who had (bizarrely in my view) built up a whole portfolio of insurance policies that insured companies against losses from sub-prime derivatives. Clearly it never assessed the risk at all, or laid off the risk through reinsurance. In other words the biggest insurance company in the world had a bout of amnesia and forgot it was an insurance company.
The short-sellers moved in. For the short sellers it seemed like the opportunity of a lifetime in terms of possible profits. All you needed to do was short sell AIG, WaMu, Merrill Lynch, Morgan Stanley and even Goldman Sax, and wait for the shares to collapse – which they all started to do. In such circumstances short selling becomes self-fulfilling and would be, even for a bank with sensible levels of asset coverage. If anyone thinks a bank is in trouble, then the truth is it is in trouble.
So on Friday the US Government threw up its hands, declared its intention to fund the financial sector to whatever extent was needed and banned the short-selling of financial stocks.
The Fat Lady
Banning short-selling sounds like a good idea until you work out what it means – and that’s no simple exercise. Here’s the thing:
If you ban shortselling, then short sellers are forced to liquidate their positions. The immediate impact is that share prices rise, because you have to buy shares to liquidate a short position. The short sellers that moved in late take a bath. But you also cripple the options market, because options are derivatives that involve short selling. So you have to make an exception for options (which is what has been done).
There is a further problem, which is that there is a vast amount of computer trading and many trading algorithms will include short-selling. Which means you have to change the algorithms. There’s no telling how much disruption that is going to cause. Eventually you have to let short selling back in – because, believe it or not, markets tend to be more volatile and less liquid under many circumstances if you don’t allow short selling.
Unfortunately this is not just a subprime credit crunch. In the deregulated Wall St, credit markets are incestuously intertwined and hence the US government must now stand guarantor for the whole credit market until a realistic and accurate value for the various derivatives that are causing the problem is established.
The fat lady has not even walked onto the stage yet. This crisis will continue (whether it makes headlines or not) for quite a while. It started on Wall St, but it won’t end ’til it gets to Main St.
A Nightmare on Wall St
“Coming soon to a Main St near you,” I could add. One of the things that distinguishes the current financial meltdown from the one that gave rise to the Great Depression is that it’s happening right in the middle of a presidential election. That’s unhelpful because there’s a disconnect between what might be sensible to propose and what might garner votes for either candidate. Luckily John McCain, in a desperate attempt to distance himself from his constant economic position of decades, has been so incoherent that it hasn’t obliterated sensible comment on what’s actually happening.
What we’re witnessing, hopefully, is the meltdown of the political theory that successfully persuaded America for the last 30 years that deregulation is a wonderful thing. It’s as if America has finally discovered that banning the umpires from the football field really doesn’t improve the game of football – it only makes it more dangerous. It may not have escaped your notice that all the currently collapsing financial institutions are American – they were the lobbiers for deregulation, then the beneficiaries of deregulation and finally the victims of deregulation. They’ve sewn the breeze and reaped the whirlwind in almost record time.
The breeze was partly sewn in 1999 with the passage of banking reform laws driven by Phil Gramm – chief economic adviser to the McCain presidential campaign – until he said in July that the current recession was only a “mental recession” and America had become “a nation of whiners.” He was promptly thrown under the campaign bus. Gramm’s reform laws removed the enforced separation between insurance, broking and banking that was put in place by FDR in the 1930s.
Bring Me The Head of Christopher Cox!
Early this week McCain called for the head of Christopher Cox, Head of the SEC (Securities and Exchange Commission), assigning some of the responsibility for the financial crisis to him, and saying that he would have been sacked if McCain has been president. One problem with that proposal is that the President doesn’t have the right to sack the head of the SEC. Another problem is that, while the SEC might have been more stringent with financial institutions that have been collapsing, it really didn’t have the oversight to affect the subprime bubble that lies at the root of this crisis.
In among the organizations that should have been called to account are Moody’s and Standard & Poors, both of which failed dismally to assign realistic risk ratings to the subprime derivatives that pervade the balance sheets of the failing institutions. However you may say that assigning the blame there is a little narrow, because what has happened in these dangerously deregulated times is that a kind of shadow banking system has evolved in America. Typically banks are forced by regulations (that dirty word again) not to over-leverage their lending activities, which ensure that they keep a sane ratio of assets to liabilities. Traders in derivatives are under no such obligation.
What Caused The Crisis?
You may be wondering why the crisis suddenly exploded given that we’ve known about the extent of the subprime mess for many months now. Here’s why:
The subprime chickens didn’t come home to roost all at once. They made their way home gradually. House prices fell gradually reducing what asset coverage they offered and mortgage holders gradually defaulted more frequently. This meant that the holders of subprime derivates were gradually being squeezed – a slow motion train wreck was how one commentator described it.
Bears Stearns was the first of the dominoes to fall, but it was conveniently snapped up by JP Morgan – a “safe” bank. Everyone knew that it wasn’t the end of the story and the banks that were in trouble were (secretly) seeking buyers. The problem was that there was no easy way to actually value the dubious derivatives, so there was no way for anyone that might be tempted to buy Lehman Brothers to know what was a justifiable price.
On Monday the US Government allowed Lehman Brothers to go into Chapter 11. That wasn’t clever. In a shadow banking system where no-one’s quite sure who has got asset coverage for what, that immediately cast a shadow over every other bank – and AIG, who had (bizarrely in my view) built up a whole portfolio of insurance policies that insured companies against losses from sub-prime derivatives. Clearly it never assessed the risk at all, or laid off the risk through reinsurance. In other words the biggest insurance company in the world had a bout of amnesia and forgot it was an insurance company.
The short-sellers moved in. For the short sellers it seemed like the opportunity of a lifetime in terms of possible profits. All you needed to do was short sell AIG, WaMu, Merrill Lynch, Morgan Stanley and even Goldman Sax, and wait for the shares to collapse – which they all started to do. In such circumstances short selling becomes self-fulfilling and would be, even for a bank with sensible levels of asset coverage. If anyone thinks a bank is in trouble, then the truth is it is in trouble.
So on Friday the US Government threw up its hands, declared its intention to fund the financial sector to whatever extent was needed and banned the short-selling of financial stocks.
The Fat Lady
Banning short-selling sounds like a good idea until you work out what it means – and that’s no simple exercise. Here’s the thing:
If you ban shortselling, then short sellers are forced to liquidate their positions. The immediate impact is that share prices rise, because you have to buy shares to liquidate a short position. The short sellers that moved in late take a bath. But you also cripple the options market, because options are derivatives that involve short selling. So you have to make an exception for options (which is what has been done).
There is a further problem, which is that there is a vast amount of computer trading and many trading algorithms will include short-selling. Which means you have to change the algorithms. There’s no telling how much disruption that is going to cause. Eventually you have to let short selling back in – because, believe it or not, markets tend to be more volatile and less liquid under many circumstances if you don’t allow short selling.
Unfortunately this is not just a subprime credit crunch. In the deregulated Wall St, credit markets are incestuously intertwined and hence the US government must now stand guarantor for the whole credit market until a realistic and accurate value for the various derivatives that are causing the problem is established.
The fat lady has not even walked onto the stage yet. This crisis will continue (whether it makes headlines or not) for quite a while. It started on Wall St, but it won’t end ’til it gets to Main St.