The Continuing Crisis Part VII

America’s sneezed a couple of times, and Germany’s catching a cold (G).  But according to a couple of recent articles, America may be in for a severe flu, which will put Germany in intensive care.

The most interesting part of the story is the subprime crisis, which we all find a transatlantic high-finance morality play (don’t we?).  Latest signs indicate it is spreading far beyond mortgage loans.  According to this MarketWatch article, bond insurance agencies are now being downgraded, which could trigger further financial meltdowns.  This article in the Wall Street Journal gives some background to the current problems:

At the center of these concerns is a vast, barely regulated market in which banks, hedge funds and others trade insurance against debt defaults. This isn’t like life insurance or homeowners’ insurance, which states regulate closely. It consists of financial contracts called credit-default swaps, in which one party, for a price, assumes the risk that a bond or loan will go bad. This market is vast: about $45 trillion, a number comparable to all of the deposits in banks around the world.

Essentially, it goes like this.  You are a housing construction firm (or a city), and you want to build a new subdivision.  You issue corporate bonds to finance the cost of the new construction.  Normally, the risk of you defaulting on your bond would be built into the interest rate: the more risk to the person who buys the bond, the higher the nominal rate (although bond valuation is a lot more complex than this in reality).

However, firms like ACA, the subject of the Wall Street Journal article, began to also offer bond insurance: for a fee, you could buy an insurance policy that would require ACA to continue paying the interest and principal on the bond if the actual bond issuer couldn’t make the payments.  Finally, very recently (only since about 2000), they began offering credit default swaps.  This is a private contract in which a bond insurer (swap seller) promises to pay some party (the swap buyer) a set amount of money if a bond issuer defaults.  These transactions allowed banks to improve their earnings reports by off-loading the risk of market-price fluctuations onto third-party insurers.

A credit-default swap is a private contract between two parties, and thus is not subject to the intensive regulation of ordinary banking or insurance transactions.  For instance, credit-default swap sellers were often not required to post anything more than nominal collateral — that is, there was no law setting an amount of liquidity they had to possess in order to make good on claims arising from the swaps.  Back in the salad days, of course, this counted as an advantage.

These mechanisms seem to have been used to further disperse the risk of default, and to "launder" riskier bonds.  That is, if a reputable, A-or-above rated bond insurer sold the insurance or swap, the swap itself would often receive a rating comparable to the rating enjoyed by the insurer who offered it — and, conceivably, higher than the risk of the underlying securities would justify.  The real problem is that this entire scheme rests on the market believing that the bond insurers’ judgment is as good as it should be; that the bond insurers genuinely deserve their ratings.  Like the high-rise apartments built by El Mistico’s powers of suggestion in the Monty Python sketch, the entire edifice starts to crumble if the bond insurers’ judgment is no longer taken at face value: when "a bond insurer is downgraded, all the securities it has guaranteed are, in theory, downgraded as well," to quote the Marketwatch piece.  This could also affect municipal bonds, which are used by American public authorities to finance new schools, sewer systems, and the like.

Now, I’m no expert here, so maybe I’ve gotten some of this wrong.  Corrections welcome in comments.

4 thoughts on “The Continuing Crisis Part VII

  1. Some wit–Gore Vidal?–said recently that Americans now make their economy run by selling each other real estate financed by money borrowed from the Chinese.

    I thought that was an exaggeration. Still do. But less so.

  2. There is a curious parallel in all this unravelling fiscal alchemy to the 1929 stock market crash. At that time a major problem was the implosion of the investment trust companies.

    The problem is that these trusts were set up using leverage to gear up the effect of asset rises on the price of the common stock. They were often capitalised 1/3 bonds, 1/3 preferred stock (which paid an annual return, and 1/3rd common. The capital was invested in shares of common stock from other corporation and trusts.

    The power of this idea is that in a rising market the increased value of the underlying shares translate into profits. Once the bondholders and preferred shares have been paid their interest the remainder of the profit went to the common stock. The effect on the common stock was roughly 3X the effect of directly buying the shares would have been, If a trust invested in the common stock of other trusts the effect could be multiplied ad-infinatum in theory at least.

    The problem was that the effect of lower prices were also multiplied. When a trust was liquified the bonds had first call on the assets of the corporation, then the preferred stock, and only then the common stock after the other categories.

    A simple trust (one which did not invest in other trusts but directly shares of real companies) worked like this: If they invested in US Steel and the price of US Steel declined 20%, the common shares of the trust would in theory decline 60% because the bonds and preferred shares shared none of the loss. If US Steel declined 33% the trust’s common shares were wiped to nothing.

    But if the trust invested in the common of other trusts the effect was much worse, because those shares declined 60%, utterly obliberating the common stock of the trust and most of the preferred stock as well. If there were another level of gearing (one trust buying another which bought into a third) the destruction was total for bondholders, preferred, and common.

    The situation today is different but the effect seems somewhat similar. If a bond insurer can en-noble the securities which it insures, then when it’s own rating is cut all the securities it insures are surely reduced in degree without regard to the underlying value of the securities.

    Anyone else out there remember Michael Miliken? Drexel Burnham Lambert? ‘Junk’ bonds? These are ‘Junk Bonds’ by another name. Miliken and Drexel became very wealthy by other means, but sorting out the wheat from the chaff in the subprime bond market is how they got their start.

    This debacle has created a helluva lot of relatively undifferentiatable junk bonds, and some smart people are goiing to makea helluva lot of money from this. Put it this way: the markets are very shy of this stuff right now and I’m certain that prices are going to go way low once the market starts pricing that.

    Let’s assume that a lot of it will drop from 100 to 50 or 60. A canny financier will try to identify securities which will default on 20% and pay 80% – and buy those securities at 50 or 60. That leaves the investors with a profit of 33-50% on investment as well as high interest on the sould stuff, a tidy sum indeed.

  3. What goes around comes around. Reading about Miliken and Drexel reminded me of something I’d forgotten – this was the case on which Rudy Guiliani made his bones. He’d indicted some Mafia dons before but this was what really got Guiliani in the headlines and pribably made him Mayor of New York.


    Keynes advised burying sacks of money and employing people to dig it up when asked how to get money in circulation during the liquidity trap that was a symptom of the great depression (when investors preferred cash even at incredibly low interest rates). Welcome back JMK! Here’s the latest from the shameless hypocrits that have brought you to the brink of a global crisis:

    Congressional Budget Office Director Peter Orszag, testifying before the Senate Finance Committee on Tuesday, said the 2001 experience suggests that expanding the pool of lower-income households who get the rebate this time would lead to an “appreciable” economic boost.

    “For any given pot of money, the more you target the lower-income, credit-constrained households, the bigger the bang for your buck,” Orszag said.

    Now it’s only a small step from here to the bright idea that a progressive income tax combined with a fiscal policy that targets lower income, credit constrained households makes economic sense generally. However, don’t expect any great steps for mankind. The volte face from free market lunacy is temporary and motivated by the hope that the rebates to the poor will go to paying their bills and end up in the banks’ vaults just as surely as if the Government bailed them out directly.

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