Sunday, October 12, 2008

Global Meltdown Dissected

Governments around the world are throwing trillions of dollars into their financial sector industries in what increasingly appears to be a failed attempt to arrest the global economic meltdown.

We didn't hear much about it, but the Brits just came through with their very own, 500-billion pound rescue package (just over one trillion Cdn.) Like the trillion dollar American deal it doesn't seem to be curing the problems.

Last weekend, 60 Minutes introduced many of us to what might be the culprit, the real malignancy in the global markets - up to $60-trillion in scam insurance contracts called Credit Default Swaps used by the big financial houses to squeeze out the last drops of profit from selling the ticking time bombs we now know as ABCP, asset backed commercial paper, or derivatives made up of bundled good and bad mortgages.

In today's English paper, The Observer, Will Hutton argues that all the government bailouts won't work without tackling the Credit Default Swaps:

What needs to happen on top is an assault on the dark heart of the global financial system - the $55 trillion market in credit derivatives and, in particular, credit default swaps, the mechanisms routinely used to insure banks against losses on risky investments. This is a market more than twice the size of the combined GDP of the US, Japan and the EU. Until it is cleaned up and the toxic threat it poses is removed, the pandemic will continue. Even nationalised banks, and the countries standing behind them, could be overwhelmed by the scale of the losses now emerging.

This market in credit derivatives has grown explosively over the last decade largely in response to the $10 trillion market in securitised assets - the packaging up of income from a huge variety of sources (office rents, port charges, mortgage payments, sport stadiums) and its subsequent sale as a 'security' to be traded between banks.

Plainly, these securities are risky, so the markets invented a system of insurance. A buyer of a securitised bond can purchase what is in effect an insurance contract that will protect him or her against default - a credit default swap (CDS).

Their purpose was a market solution to make securitisation less risky; in fact, they make it more risky, as we are now witnessing. The collapse of Lehman Brothers - the refusal to bail it out has had cataclysmic consequences - means that it can no longer honour $110bn of bonds, nor $440bn of CDSs it had written. On Friday, the dud contracts were auctioned, with buyers paying a paltry eight cents for every dollar. Put another way, there is now a $414bn hole which somebody holding these contracts has to honour. And if your head is spinning now, add the three bust Icelandic banks. They can no longer honour more than $50bn of bonds, nor a mind-boggling $200bn of CDSs.

While every bank tries to pass the toxic parcel on to somebody else, the system has to find the money. So will compensation for the near valueless contracts and thus now uninsured debt ultimately be made - and by whom? And because nobody knows - not the regulators, banks or governments - who owns the swaps and whether they are credit-worthy, nobody can answer the question. Maybe holders of insurance policies will get the cash due to them, but will that weaken somebody else? The result - panic.

This is the ultra-dangerous downward vortex in which the system is locked. It is why share prices are plummeting. As recession deepens, there will be defaults on securitised bonds and the potential collapse of more banks outside the G7 ring-fence. Nobody knows what proportion of the $55 trillion of credit default contracts that have actually been written will be honoured and who might bear losses running into trillions of dollars.

One element of the necessary response is in the making - giving banks access to unlimited taxpayers' capital, guaranteeing interbank lending and pumping cash into the system. I suspect that only majority government control of the West's major banks will now stabilise matters. But that is not enough. The markets no longer believe in the financial market structures they have invented. As a result, the US Fed, the European Central Bank, the Bank of Japan and Bank of England must become not just lenders, but insurers of last resort, providing the insurance contracts that the markets have stopped. Governments must write CDSs themselves.

Most of those who should be leading the world's recovery are, politically speaking, numbered among the politically walking wounded or dead; either near the end of office like George Bush, in a fractious coalition like Angela Merkel, or leading a dysfunctional party like the weak Taro Aso of Japan.

For 30 years, greedy, callow, ignorant financiers, supported by no less callow politicians from all the political parties, have proclaimed the wonders of financial innovation and how proud we all should be of the City of London. The price tag for their behaviour is an economic calamity. We should never have bought such snake oil. The consolation in these dark times is that we never will again.

What I find most vexing about these Credit Default Swaps is that they were essentially fraudulent. McCain economic advisor Phil Gramm introduced and spearheaded the legislation allowing these contracts and preventing anyone from regulating them. By calling them "swaps" (they could just as easily have been called doorbells or mustard) instead of "insurance" they remained outside the purview of US regulators. And yet they were in every respect insurance contracts. What set them apart and has led to the crisis today is that they were unfunded obligations that were, themselves, traded as securities. Regulators make sure that insurance companies have enough assets to meet their obligations. No one required that for GDS's.

To my simple mind, selling what you know to be an insurance contract while knowing you have no means to satisfy your obligation is fraudulent. It's like me selling you my neighbour's car and pocketing the sale price. I can't deliver what I've promised - title to the car - because I don't have it.

Phil Gramm & company have unleashed an economic maelstrom on everyone and somebody has to atone. The US government in particular ought to be lining up all those good Republicans who perpetrated this fraud - the CEO's and the executives of these investment banks and insurance companies and securities houses - and they should be marched away in irons. Everyone who facilitated the perpetration of this, the greatest and most cataclysmic swindel in history, ought to be slung into a cell, stripped of every penny of assets and locked away forever. The lasting damage each of these kingpins has caused makes any serial killer look like a jaywalker.

No comments: