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Thursday, August 16, 2007

Wall Street deep in the tranches

My crystal ball is unavailable because it was backed by a mezzanine level tranch, but you gotta wonder when the chorus of free market absolutists demanding free government money will commence in earnest. Consider this tidbit from Roubini Global Economics Monitor, via Eschaton:
Here are two examples of how uncertainty and opacity has vastly increased in financial markets.

First, you take a bunch of shaky and risky subprime mortgages and repackage them into residential mortgage backed securities (RMBS); then you repackage these RMBS in different (equity, mezzanine, senior) tranches of cash CDOs that receive a misleading investment grade rating by the credit rating agencies; then you create synthetic CDOs out of the same underlying RMBS; then you create CDOs of CDOs (or squared CDOs) out of these CDOs; and then you create CDOs of CDOs of CDOs (or cubed CDOs) out of the same murky securities; then you stuff some of these RMBS and CDO tranches into SIV (structured investment vehicles) or into ABCP (Asset Backed Commercial Paper) or into money market funds. Then no wonder that eventually people panic and run - as they did yesterday – on an apparently “safe” money market fund such as Sentinel. That “toxic waste” of unpriceable and uncertain junk and zombie corpses is now emerging in the most unlikely places in the financial markets.

Second example: today any wealthy individual can take $1 million and go to a prime broker and leverage this amount three times; then the resulting $4 million ($1 equity and $3 debt) can be invested in a fund of funds that will in turn leverage these $4 millions three or four times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them three or four times and buy some very junior tranche of a CDO that is itself levered nine or ten times. At the end of this credit chain, the initial $1 million of equity becomes a $100 million investment out of which $99 million is debt (leverage) and only $1 million is equity. So we got an overall leverage ratio of 100 to 1. Then, even a small 1% fall in the price of the final investment (CDO) wipes out the initial capital and creates a chain of margin calls that unravel this debt house of cards. This unraveling of a Minskian Ponzi credit scheme is exactly what is happening right now in financial markets.
I thought we learned about this in 1929. I mean really, what the heck do they teach at business schools? How to screw people over? Yeah, right, dumb question.

It's not that markets shouldn't be regulated and even backed at times by government money, it's that the elites who rule this country like to pretend that their wealth comes from their own merits and that people less well off have comparatively fewer merits. This is not only antithetical to the concept of democracy, but it is destructive in the long term to everyone's well being, at least in economic terms. A rising tide may lift all boats, but it's gotten to the point that only those with yachts get a berth at the dock. Everyone else is left to bob in the waves and hope they can find shelter when needed. Panic on Wall Street isn't so funny when everyone's retirement money is at risk.

So it's aggravating as heck when popular efforts to provide ordinary citizens with better services in health care and education, for example, are called "socialism" when the financial world gets bailed out about once every ten years or so. (See Savings and Loan crisis, The, circa. late 1980's, and Long Term Capital Management, circa late 1990's.)

It's in everyone's interest to make sure the markets continue to function, but it's also in everyone's interest to have a healthy and well-educated population.

The two are only mutually exclusive because political and financial elites in this country want it that way. Everyone knows the greatest economic expansion in history coincided with the GI Bill and the unionization of the work force after World War II. People had skills and money, and broadly speaking this is a good thing. I think Keynes established that about 1932 or so.

But the free market absolutists still believe The High Holy Writ of the Cocktail Napkin, conveniently ignoring the massive inputs from deficit spending over the years. If you're reminded of an old joke about "trickling down," you're not alone. If my leverage ratio was 100-1 I'd probably have some trickling going on, too.

UPDATE 11:55 AM PDT -- Here comes the Fed. From The Boston Globe:
The market seemed unfazed as the New York Fed -- which carries out the central bank's market operation -- announced an overnight repurchase agreement worth $12 billion. This was on top of a 14-day "repo" worth $5 billion announced before the market opened.

Central banks around the world have been supplying billions of funds to banks in the past week to make cash available for lending and keep interest rates from rising amid signs that credit was drying up. The Fed uses a repo to buy securities from dealers, who then deposit the money into commercial banks.

But, it has done little to offset fears about steeper losses for financial institutions squeezed by weeks of volatility that showed no signs of abating. Analysts contend many institutional investors want the Fed to be even more decisive.
I hear a distant whisper on the cool August seems to be whispering "bailout, bailout." I'm sure lower interest rates would cause credit card companies to pass those savings on to consumers.

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