Murky Crisis

One of the Wall Street's better maxims advises: Never let your competitors smell blood. Talking too much can injure perfectly honorable firms because in business there is usually a vulnerable time before opportunities can be consolidated, or miscalculations corrected. Trial and error innovation is progress. Transparency, humbug.

This prevailing wisdom can lead to mysteries like the present one, where thousands of well informed professionals struggle to puzzle out an explanation for pretty dramatic events, yet after six months no one can be entirely sure how bad things really are. When the subprime credit crisis began in August 2007, the number of outstanding mortgages was quickly approximated, and from that it appeared impossible for overall losses to exceed $90 billion. Six months later, write-offs at least that large have been declared, but estimated future losses now range around $600 billion, give or take $300 billion. But wait, in a zero-sum game, winners must match losers so the economy as a whole should remain unchanged. Even if winners and losers are in different nations, the result would at worst be weakening of one currency and strengthening of the other; after the adjustment world-wide wealth would remain unchanged. Real world-wide losses in a crash relate to whether wealth is created or destroyed, not whether it has been transferred from one firm to another. As an aside, the supply-side viewpoint is that taxes effectively remove wealth from the private sector for protracted periods and therefore are equivalent to dropping into a black hole; but liberals mostly dispute this, so it is not discussed here.

One of the indisputable ways to expand or contract wealth is, unexpectedly, through a change in prevailing interest rates. When interest rates rise or fall, the value of debt or bonds goes in the opposite direction. So, when derivatives or efficiencies lower interest rates, wealth is created. When realism, panic -- or fear of inflation -- cause interest rates to rise, wealth gets destroyed. What matters most to individuals is whether they own bonds during the time when interest rates are changing. No one necessarily gets any richer; in an inflation, bondholders lose money because money truly disappears. The only way to make money in this situation is to sell short, but that's too special and too small to affect this discussion.

So recently, spreads widened, or the risk premium returned to historic levels, or subprime mortgages got more expensive, or six other ways of saying the same thing: interest rates went up, value was destroyed. Anyone holding a certain kind of bond lost money, and may not be able to pay his bills. Because the problem was large and world-wide, no one could be sure who was holding the bag, transactions stopped, the credit market "froze up". Some very prominent firms soon declared losses of $5-10 billion each, so anyone might be an unsafe counterparty. Even if time passed and other firms did not declare losses, general distrust persisted, for a complex reason.

A Wall Street broker is required to mark to market, every day. Active traders, trying to keep as little inventory as possible, constantly face the possibility of imbalances, temporary cash shortages, which would make them unable to pay bills. Therefore, when interest rates go up, Wall Street investment firms lose a lot of money on the underlying bonds in their hands and must declare so publicly. Firms hate it, because it could well trigger margin calls from their lenders. If no shares are traded, however, the price of the shares appears to remain at its price at the last trade. That's what is often meant by markets "freezing up" ; if no one registers a sale at a lower price, it can't be meaningfully "marked to market." Banks, by stark contrast, are allowed to play by different rules. When the value of their bonds or other securities goes down, the accounting rules permit them to declare the bonds are a long-term investment, where they do not need to be marked to market. Investment banks thus must declare huge losses when they haven't sold anything, while commercial banks may hold exactly the same portfolio and declare no loss at all. Whether this disparity is fair or unfair, wise or unwise, is entirely beside the present point. The disparity confounds the general inability to say who is in trouble, thus whether the economy is in dire straits or just experiencing a state of confusion. At the least, it makes banks appear to be solid and solvent, while other investment institutions may appear to be in worse trouble. Aside from investors losing money by making wrong choices, there is a political risk in an election year that Congress or regulators could make wrong choices. A reckless young French trader happened to underline this risk, quite pointedly.

America was having a bank holiday on Martin Luther King's birthday, so our financial markets were closed but European markets were open. While American traders sat helplessly at home watching the news, European stock markets abruptly collapsed on heavy selling. Federal Reserve Chairman Bernanke promptly dropped short-term interest rates by seventy-five basis points (0.75%) between meetings of his board, creating a panic situation the next morning. It seems in retrospect that he had not been informed that a rogue trader at a prominent French bank had obligated that bank for $75 billion of unauthorized positions, which bank authorities promptly liquidated at a $7 billion loss soon after they discovered it. The newsmedia concentrated on the racy story of a French scalawag, but there was a more important story. Because of bewildering financial convulsions whose full dimensions may not be known for another year, Ben Bernanke the financially best-informed person in the World got into a panic and made a choice he might not have made if he had the full facts. If that was the case, poor intergovernment communication unnecessarily gave us a dose of inflation to contend with. Or, perhaps Bernanke got a needed wake-up call that the economy risks getting tangled up for several years by banks trying to ride out their bond portfolios to maturity instead of making loans. Refusing to acknowledge losses is what gave Japan a recession which is now in its fifteenth year. Try this nightmare: if the American consumer quits buying imported goods, Japan then China could collapse with consequences beyond conjecture. It is impossible to imagine Congress restraining itself in such a mess, and nearly impossible to imagine their getting it right when they do act.

As if to illustrate the point, the Carlyle Capital collapse in March 2008 demonstrated how violently markets can now be roiled by even a small quirk in the banking system when huge volumes of money are propelled through it by computers before the rest of the financial world wakes up. A prudent banker would normally make a loan for appreciably less than the value of the collateral. Depending on the historic volatility of the collateral, it might be reasonable to lend 80%. But Carlyle was an investment fund, selling shares to the public worth several hundred million dollars. Borrowing $20 billion from banks, especially Deutchebank, Carlyle bought mortgage-backed securities for the investment fund. Before things collapsed, Carlyle had bought $21 billion of real estate loans but had received only a twentieth of that from investors. The market price of the secutities thus only had to fall by 3% before the whole structure became insolvent. In the conventional 80% collateral example, a 3% decline would still leave it with a 17% cushion. Extreme leverage of this new sort would probably never have been considered by the German bank if it related directly to mortgages without a complicated middle-man. Whether anyone at the German bank realized this transaction was substantially the same thing at 20 times the risk is presently unknown, but it seems doubtful. The fact that at a relatively quiet moment DB suddenly called back its loan suggests that someone at the bank finally did wake up and ordered an end to the arrangement. Congress can now pass a law forbidding such structures if it wishes, but that will be mere grandstanding. Future textbooks of banking practice will surely all riducule the absurdity of this transaction; the risk of it nearly vanishes however at the moment of its wide spread recognition for what it is. Far worse would be for Congress to pass pious laws which essentially say that nothing innovative must ever happen for the first time, or that banks must stop using high-speed computers.

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