Tuesday, October 7, 2008

The Black Hole

If anyone still thought that the Wall Street bailout was a good idea, I would hereby like to put that sentiment into some perspective. When the bailout was approved in the house of representatives, Wall Street yawned, already knowing that in the near future it would be able to carry out the strategy that it had had from the very beginning when it started to promote the bailout: to take the money and run. The stock market did not rally after the vote, as anyone who knows anything about Wall Street knew that it would not, and on Monday of this week, it seemed that the stock market was heading for a crash before it recovered. The politicians must be so confused by now, because they were told that this bailout was going to solve everything. What they did not know was that they were being lied to repeatedly. If the Bush years have taught us anything, it is that, sometimes, ridiculous conspiracy theories are true.

 

The biggest problem with the bailout is that it is wholly inadequate and directed incorrectly. As we all know, these toxic securities are worthless because there is no market for them. Apparently, a lot of people who previously bought them, and even the people who sold them, knew that too back in the day. This is evident because investors bought insurance against losses on them, called credit default swaps. The reason that these products are not called insurance is that that would require…. you guessed it: regulation. It turns out that the companies who sold the toxic securities, like Lehman Brothers and Bear Sterns, also sold insurance against losses on them. In such a case, you can think of it as the extended warranty that you can buy for a new computer.

 

Now, most of what we have heard as of yet in this financial crisis is how these securities are worthless, and how much of a problem that is for those who own them. What Wall Street is not talking about, and may not be fully aware of, is the fact that, in many cases, that’s someone else’s problem.

 

Imagine if Dell had sold 100 million computers in the United States in one year. Every one of the customers also bought an extended warranty with their new computer. Then imagine that there is a completely fatal error on the motherboard of every one of the 100 million computers, which makes the whole machine completely unusable after one year. Dell would then have to pay about $100 billion to replace all the computers, which is something that it could obviously never do.

 

This is a SMALL-SCALE example of what type of problem awaits us with the credit default swaps. The companies who sold both securities and credit default swaps had to buy the swaps from a different company (as if Dell had insured its own computers with Hewlett Packard insurance and vice versa). Nobody knows how much of this insurance money will have to be paid, because the companies who sold the “swaps” do not have to disclose any details about them. However, according to voluntary surveys (which only some companies responded to) there is over 50 TRILLION dollars worth of them. Then count the companies that did not respond, and the companies that were less than truthful about the size, and it is not improbable that the number in reality is close to $100 trillion. Now consider the wisdom in throwing away $700 billion of taxpayer money into this black hole. It turns out that the black hole was insured! I have said it before, and I’ll say it again: banks and Wall Street firms are hiding how many bad assets they actually have. Why would they insure the assets for $100 trillion if there are only $700 billion dollars worth of them in existence???

 

Very few people know exactly how these insurance policies work. It is plausible, however, that we will see much bigger effects of them when the bailout program actually starts buying the toxic securities. As companies start realizing their losses by selling securities to the government, money will start pouring in from all directions:

 

1.Taxpayers will have to grossly overpay for the securities (which I will return to another day)

 

2. Companies can use the loss of the sale to decrease their taxable income

 

3. The credit default swap mechanism should pay money to the company selling the securities to taxpayers

 

The third step will be the hardest, because the companies who sold the credit default swaps definitely do not have the money to cover all the losses. They wouldn’t even have been able to cover smaller losses, because they did not keep capital reserves to be able to do so (because they were not regulated). In other words, the companies who sold both securities and credit default swaps will first be flush with taxpayer cash because of the bailout, then go bankrupt because of the swaps. After that, panic will ensue when people realize the magnitude of the problem.

 

All we can do now is to let it all happen, and pick up the pieces when it's done.

7 comments:

Avatar said...

Do you have a Private mortgage insurance (PMI) policy? If you do your PMI insurer has passed along their risk by buying a credit default swaps (CDS) to protect them in the event you have your home that your home is taken away from you. CDS and PMI are the same thing. Make people wanting to buy a home put at least 20% down if you don't like them. nomedals.blogspot.com

Lisa said...

Jacob, I'm not very good with economics but I'm trying to understand this situation because I find it fascinating. Let me ask you this-- You say these toxic securities/assets are worthless, but these securities represent property or real estate somewhere, don't they? What exactly makes them worthless right now? Because they're lumped into such big bundles?

Also, are you saying it was just *recently discovered* that $100 trillion of insurance (default swapage) was purchased against these securities? And if so, is this something that the Treasury Secretary knew about before he devised the bailout plan?

Your article is fascinating.


-Lisa

Jacob said...

Lisa,

although it is true that there is real property somewhere behind these securities, that is not necessarily relevant. When you buy a security like this, you're really assuming a lot of risk while hoping that everything will be OK. Imagine that you want to buy a nice cat, but you don't have any money. You go out in the street and pick up a feral cat, bring it in to your home and hope that it will somehow turn into a nice purring cat. Sometimes it does (I have a very nice cat that came from the streets of The Bronx), but often it does not. The cat may have pretty eyes and nice fur, but that doesn't make up for the fact that it would be impossible to keep in the house. So it is with these securities, they cannot be broken down into pieces, they are relevant only in their totality. Apart from the fact that a lot of houses have lost 50% or more of their value, som have lost ALL of their value, because they have actually been torn down.

In Europe, there is a solution to this problem. The way that a lot of European banks solve this problem is to offer what is called "covered bonds". That is similar to mortgage securities, but as soon as one piece of the totality goes bad (one house loses value, for instance) it is immediately taken out of the pool, and several banks share that cost at once.

Of course the Treasury knew about the problem with the credit default swaps before devising the plan. The bailout plan was never intended to help taxpayers, it was intended to bail out individual companies, executives and shareholders. To say that it will eventually bring back value to people's 401(k)s, for instance, is laughable.

Anonymous said...

Jacob:

I found your blog by reading the comments section in the NYT and I must say that you are really helping me grasp what is going on. You are able to put this issue in plain, simple English that an average non-economist like myself can understand.

Keep writing and I'm sure your readership will pick up greatly.

Now, onto a question I have. What exactly is the treasury going to do with this money? are they going to literally wire it into the bank accounts of firms like Goldman and AIG?

And if these financial firms ALREADY knew that the $700 billion would not cover their debts, why did paulson even bother printing the money? Wouldn't it have been better for paulson to use the money to help homeowners stay in their homes?

I look forward to reading your answer.

Jacob said...

Anonymous,

as of now, things have changed radically. The Treasury will probably no longer buy the troubled assets, but instead buy stocks in banks. The corruption in the original plan was made even clearer when Paulson hired an old pal from Goldman Sachs with only a few years experience to run the program. All that is gone now. It seems that the U.S. will now do what the Swedish government did 15 years ago: partly nationalize banks. This is the only thing that has a real chance of working, so that is good.

Anonymous said...

Jacob,

How do you know that paulson's young colleague from Goldman is no longer running this bailout program?

How do you even know what they are going to do with the money? Who is controlling it? Based on what I've read, congress doesn't seem to want to any oversight responsibility over this mess.

Who has legal control over this money?

Jacob said...

I don't know for sure, but the writing is on the wall. A lot of things that have happened lately have been illegal, such as the AIG bailout. This is a bona fide crisis, and everything is grey as of now. There is no clear legal authority and everything is up in the air. At this point, the IMF and the World Bank are getting involved, and you better believe they're not going to let some snot-nosed Goldman Sachs trader run the show.