Reason for economic crisis

[chartman]

I read this posting in another forum so I thought I would post it in ET for your comments and discussion.
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Avis & BT seem to think the way we 'got here' is through some mechanism of productivity vs debt as it relates to GDP. Or something like that.

I'm sorry that's simply not correct. It ain’t even close.

How we got here is… the world banking system lead by Wall Street brokerage/banks/insurance companies created a world wide insurance scheme based on mortgage backed credit default swaps and derivatives of the CDS assets (aka toxic assets) that are on their books for many trillions dollars that NOW no one knows how to value. Fact is a very large percentage of these CDS derivatives may simply be worthless.

The CDS assets are bundled ‘mortgage insurance policies’ not the actual mortgages. The derivatives are a kind of stock based on the value of the underlying policies. The derivative stocks was traded so aggressively the stock price rapidly appreciated even though the underlying value of the insurance policies remianed unchanged. Everybody was making big BIG money selling insurance and trading stock. Everybody wanted a piece of the action. It spread like wildfire throughout the world financial markets (check out the Icelandic banks… Iceland !!) as a way to reduce risk and make a ton of money doing it. Where this scheme came off the tracks was when the deregulated financial companies morphed into ‘insurance’ companies, they were not required to carry requisite cash reserves against claims (unlike their heavily regulated REAL insurance company cousins). So even a minor up tick in mortgage failures caused huge ‘unanticipated’ cash requirements that the brokerage banks couldn’t cover. When that minor up-tick turned into a major up-tick they started dropping like flies. Thus Lehman Bros., Bear Stearns, Merrill Lynch et al.

When the actual value and the implications of holding tons of CDS and derivative assets started to be recognized, the whole system locked up. Everyone had huge CDS exposure that couldn't be liquidated (sold) without committing corporate suicide (because they’d have to be sold at a small fraction of their booked value). Remember the term ‘illiquid assets’ ? There you go. That’s what they were talking about.

Credit locked up. Who in their right mind would be lending money to another financial institution who could go bankrupt at any time, without notice ??

Remember when this thing first broke ? Remember the glazed over look they all had after their initial briefing at the GW White House. They were stunned !! They had no idea how to fix the problem.

They/we still don’t !

Believe me we won't be able to print enough dollars, pounds, euros, yen combined to 'buy up' what could be 20- 50 trillion dollars of worthless credit default swaps. It ain’t gonna happen !

So what to do ?? I ain’t gotta clue.

The reason everyone close to the issue is willing to throw so much money at the economy is to give them time to figure out how to purge that much money off the bank’s books without causing the whole thing to collapse. They are buying time. Plain and simple. Let’s hope they don’t run out of money before they figure it out.


So while increasing debt without sufficient productivity to pay for it is bad. It’s not ‘how we got here’. There are things out there that are much much worse!

 

[Daal]

You forgot to add 'print money'

 

[chartman]

"You forgot to add 'print money'"
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Believe me we won't be able to print enough dollars, pounds, euros, yen combined to 'buy up' what could be 20- 50 trillion dollars of worthless credit default swaps. It ain’t gonna happen !

 

[jjf]

If TPTB had forced all financial institutions to disclose all off-book dealings some months ago, then we would know who owes what to whom by now.

If the circle of liability is perfect then just cancel everything.
If it is irregular then the size and shape of the problem can be dealt with.

It is important to remember that every piece of string has two ends, but it is still one piece of string.

Without full disclosure, the taxpayer is being sucked down a never ending hole by the banks.

 

[Humpy]

Quote from Daal:

You forgot to add 'print money'

The Robert Mugabe school of economics says print money. The idiot has banknotes with a face value of billions and are completely worthless. His economy to recover will have to go back to 1,000 years ago European time ( 200 years African time ) and slowly but surely re-build his economy with BARTER.
The mixture of Socialism and greedy crooks has caused this crisis on top of what chartman says. It'll take a strong and ruthless dictator to sort those bastards out. So hang in there folks for a really bad experience imho

 

[Traden4Alpha]

Quote from chartman:
"You forgot to add 'print money'"
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Believe me we won't be able to print enough dollars, pounds, euros, yen combined to 'buy up' what could be 20- 50 trillion dollars of worthless credit default swaps. It ain’t gonna happen !

First, the situation is not as bad as you think because that $20-$50 trillion in CDS is only the notional, not the actual value of these things. The notional means that CDS provide insurance against defaults on $20-$50 trillion in debt instruments including mortgages, corporate bonds, municipal bonds. You can even get CDS to cover defaults on US Treasuries (which have risen in value lately!). The $20-50 trillion number only comes into play if every corporation, government, and mortgage everywhere goes into default AND 0% of the loaned money is recovered. You can think of CDS as being like puts on bonds (with a strike price of par and exercise terms tied to defaults). The seller of the CDS/put only makes the worst-case pay-out if the bond defaults and nothing is recovered.

Many CDS (but not all) are worthless in the same way that many (but not all) mortgages are worthless. If the writer of the CDS can't make the pay-off, the CDS is worthless in the same way that a mortgage is worthless if the borrower can't pay the mortgage.

Second, the situation is worse than you think because all these CDS are assets that protect the value of bond and loan portfolios and that back a lot of liabilities of bank and non-bank institutions (including insurance companies and pensions). To the extent that the CDS system fails, a lot of banks and non-banks will have a hard time meeting their obligations to people.

What's happening is a deleveraging -- people, banks, companies, and government are being forced to unwind unsustainable obligations. That means that a bunch of people and companies are going to have to find a way to accept that their assets (including homes, checking accounts, pensions, jobs, insurance policies, etc.) are worth less than they thought they were. Printing money can accomplish much of this (inflation devalues all assets), restructuring debt will help some of this, bankruptcies will help some of this, and unilateral cuts in benefits will help some of this. It's all survivable, but it won't be pretty.

 

[chartman]

This is another posting I thought might be interesting on this subject. This is not my posting but was on another forum.
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I'm well aware of the CDS/MBS issue and why the credit markets are currently frozen. The CDSs were a time-bomb waiting to go off and the collapse of the sub-prime mortgage market was the triggering event. This time-bomb could not have been built to its size without the excessive leverage that was taken on by investment banks.

In 2004 the leverage ratio limits were removed from the major investment banks, enabling them to play more balance sheet and borrowing games like CDSs, building them into the monster that they are now and making these firms extremely vulnerable. Initially there was a 12:1 limit on borrowing. This is to provide a reserve in times of turbulence, like, say, sub-prime mortgage defaults. By the time Bear Stearns collapsed they were leveraged 33:1. Other investment firms are equally over-leveraged. This article explains it all nicely: http://www.iht.com/articles/2008/10/03/business/sec.php

At the heart of this issue was a lack of oversight and a staggering amount of incompetency in our regulatory agencies. You see in the above article that the SEC based its regulatory oversight on the bank's computer models, essentially handing oversight over to the banks themselves. Simply incredible stuff there. And before the partisans start blaming the Republican administration for everything, go look up a bit of depression-era legislation that was repealed by Clinton in 1999: the Glass-Steagall Act. This act intended to prevent the circumstances of the last depression by separating commercial banks from investment banks and ensuring that commercial banks could not play risky games with their depositors' money. Here's a good summary: http://www.investopedia.com/articles/03/071603.asp

Regulatory failures paved the way for this mess, but beyond that the simple issue here is excessive DEBT. The CDS monster would not have been possible if commercial and investment banks alike could not have borrowed 20-30 times their value. Americans would not have started massive mortgage defaults (triggering the above time-bomb in securities) if they had not been buying houses at over three times their annual salary, maintaining debt-to-income ratios of 45% and higher, while simultaneously running up multiple credit cards and financing new cars every three years. We can make credit as cheaply available as we want, but eventually we have all of our shiny new things and the bills are due. We lack the capacity to pay our debts, and here we are. If America was busy and still happily paying their mortgages, the MBSs would still have value, as would the CDSs.

Back to solving this: The real solution here is to force the investment/commercial banks that are holding these toxic assets to force those assets into the open and let the market determine their value. If this makes them instantly bankrupt, then we allow them to go bankrupt, restructure, and if possible, recapitalize them with fresh reserves. The bad debt is gone, but we once again have a solvent bank that can resume responsible lending instead of the zombie banks we have now that are just sucking capital from our system. This will HURT. The market will hate it, a lot of investors will lose their money, but we will have a fresh start and can start rebuilding. The alternative is to set up the mother of all debt bombs, by piling debt on the back of the Treasury and the Fed, and that is what we are doing now. It will buy us time but we will be worse off for it. I think the market is already losing patience. As you said, there is no amount of money we can print or borrow to dig us out.

We will not suffer a collapse of our banking system if the big banks go bad. There are hundreds of local, regional, and national banks that were responsible and are still solvent that can step up to the plate. The rock of our banking system is the Fed. If it is solvent, I have faith in our banking system for the future. The more we allow the Fed to buy up toxic assets, the less faith I have. Better to risk the stability of our wall street banks than our nation as a whole.