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Rebuilding the Global Financial System (part 1)

Lipstick on a Recycled Pig We are at the point in the global financial crisis where we should ask what is to be done. A number of commentators are already posting their theses for restructuring the international financial system, so it is high time we do so here. What can really focus the discussion is a conversation I had over the Thanksgiving holiday. The person I had the conversation with did not have a background in business or finance, so it was useful to present the discussion in a way someone on Main Street (not Wall Street) could understand it.

Not Enough Pigs With Lipstick to Recycle

The first question my guest asked was “how did all of this happen?” I gave the typical Wall Street/Washington dodge of, “well, it is long and complicated and would take hours to explain to YOU!” My guest, a brilliant attorney of many decades, though mathematically challenged, said, “but all of these right-wingers and Fox News say that it was all caused by sub-prime and Jimmy Carter and the CRA.” Good lawyers know how to bait a witness and I was no exception at this point, so I had to respond, so here is how I answered my non-Wall Street guest:

I. Right-wing talking points on sub-prime are lies

Sub-prime lending had little, if not nothing, to do with the crisis at hand. If there is any trouble in housing and real estate as a whole it exists in the prime residential mortgage and commercial sectors, both of which are far larger than was sub-prime. What is really telling are the numbers.

Sub-prime isn’t the cause, it’s really just small-prime

According to the Chicago Fed, the U.S. 2006 residential mortgage market was $10 trillion in size (all mortgages), of which sub-prime was worth $1.5 trillion. Now, if sub-prime was the culprit couldn’t the government just bail out every single sub-prime mortgage and we’d be done with it? After all, we more than have the money (TARP, AIG, Citi, Fannie/Freddie bailouts total well over $1.5 trillion). The market would rally, Dow 20,000, President McCain, Bush would be God and Fox News would be Gospel.

For that matter, add in $400 billion of Alt-A mortgages from 2006 (mortgages that sit between sub-prime and prime), now we are at 20% of the $10 trillion market for residential mortgages. Seems like sub-prime is really just small-time and a form of right-wing disguised discrimination. More D words to add to our D-Watch, sadly.

II. The problem is the foundation

All of global finance rests on credit as a mechanism for clearing transactions. By its very nature, all credit must be secured by good and valuable collateral.

What happened is that credit was created out of thin air, it was not secured against any collateral. To put this simplistically, it means that I lend you $5 now, you owe me $10 tomorrow, but we both know you have no means or assets to pay even $1 back.

Bad foundations make for falling houses

The best illustration of the problem of uncollateralized no due diligence lending is the credit default swap (CDS) market. A CDS is a contract (for a fee) between a holder of a bond and an “insurer” that in case of an event of default (say a bond default) the insurer will take collateral from the holder and repay the holder for their losses.

Here is where the foundation gets shaky. There is no foundation! Parties to a CDS contract don’t actually have to hold the reference instrument. In other words, we can agree on this insurance contract without any assurance that either one of us holds the thing we are insuring against. Also, unlike regulated insurers (your car, health or life insurance), there are usually no capital requirements, so when the non-asset holding insured goes to collect, he may find out that the insurer is insolvent!

III. How big is the CDS problem?

Few outside of high finance ever heard of a CDS before 2008 and my Thanksgiving guest mentioned that none of the main stream media (MSM) ever report on this. Here is the reason why, sub-prime is easy to understand and easy to manipulate emotions. Not so with something like CDS. But the CDS market is a $35 trillion market, far larger than all of U.S. housing combined.

So, what caused the crisis?

  1. Un-collateralized lending laid the groundwork for potential mass credit defaults.
  2. Mass credit defaults occurred due to various market disruptions (energy prices, real wage declines, global instability, profit taking, . . . )
  3. Fear of further defaults on un-collateralized credit has caused a seizure of the credit system and disruption of economic activity. This creates solvency problems (not liquidity problems).
  4. Removal of credit and economic activity contracts money supply and lowers valuations leading to deflation.

That’s the crisis in a nutshell. Up next, what to do about it.

And that’s how it goes . . .

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