Waiting for the tsunami

The sudden collapse of shares in the Centro group following the announcement that they were having trouble refinancing their debt (there’s been a partial recovery today) reminds us that no-one really knows what is going on in global credit markets. Bad debts have been buried under layers of collateralised debt obligations, and seemingly sound companies may (or may not) have all kinds of off-balance sheet obligations, liable to be called in at short notice.

Given that we are collectively among the most indebted people on earth, we probably ought to be more worried than we are. But, as Costello and Howard found during the election campaign, it’s hard to stir up concern about a possible crash when we’re still worrying about whether strong growth will overheat the economy.

Individually, the only real preparation for a possible jam in credit markets is to make sure that we are not relying on the availability of credit on easy terms in the near future. For example, if you are planning on refinancing a home loan and locking in a fixed rate, you might think about doing so sooner rather than later (note: I’m not a financial adviser, and this isn’t financial advice – if you’re actually in this, or a similar, situation, consult a professional).

76 thoughts on “Waiting for the tsunami

  1. Katz at 48,

    you call that huge money?

    THIS is huge money:

    For the 11th year in a row, the U.S. Government Accountability Office (GAO) was prevented from expressing an opinion on the consolidated financial statements of the U.S. government–other than the Statement of Social Insurance–because of serious material weaknesses affecting financial systems, fundamental recordkeeping, and financial reporting.
    David M. Walker, the Comptroller General of the United States and head of GAO, did note some progress in this year’s audit. This year GAO expressed an unqualified opinion on the fiscal year 2007 Statement of Social Insurance, which includes the Social Security, Medicare, Railroad Retirement, and Black Lung programs. This is significant because the statement covers some of the largest numbers in the federal government–tens of trillions of present-value dollars associated with future social insurance expenditures.

    Overall, however, Walker was not satisfied. In a speech today at the National Press Club, he said, “If the federal government was a private corporation and the same report came out this morning, our stock would be dropping and there would be talk about whether the company’s management and directors needed a major shake-up.� Walker urged greater transparency and accountability over the federal government’s operations, financial condition, and fiscal outlook.

    Despite improvements in financial management since the U.S. government began preparing consolidated financial statements more than a decade ago, three major impediments prevent the U.S. government from obtaining a clean opinion: (1) serious financial management problems at the Department of Defense, (2) the federal government’s inability to adequately account for and reconcile intragovernmental activity and balances between federal agencies, and (3) the federal government’s ineffective process for preparing the consolidated financial statements.
    “Until the problems outlined in our audit report are adequately addressed, they will continue to have adverse implications for the federal government and American taxpayers,� Walker said in a letter to the President and Congress. “The federal government’s fiscal exposures totaled approximately $53 trillion as of September 30, 2007, up more than $2 trillion from September 30, 2006, and an increase of more than $32 trillion from about $20 trillion as of September 30, 2000,� Walker said. “This translates into a current burden of about $175,000 per American or approximately $455,000 per American household.�

    The GAO report is here.

    Click to access d061138cg.pdf

    I hope that Professor Quiggin does not mind me quoting this passage at length, because what the head of the GAO is sounds pretty important to me. US government debt has reached an immeasurable size. I’ll say from the outset that I don’t know anything about economics, but surely the fact that the government of the world’s largest economy is, seemingly intentionally, creating a monster fiscal crisis on a scale never before seen must have something to do with all this Tsunami talk. Explicit government liabilities rising by over 3 TRILLION in five years! Fiscal exposures increasing by 32 TRILLION since 2000? This increased debt is going directly to the top one percent of income earners in the States courtesy of the craziest tax cuts in history – and probably into the top one percent’s hedge funds. But I don’t see anybody mentioning the Bush Administration in any of this, so maybe it’s not as bad as it sounds. I’ll note though that at the recent OPEC meeting some producers were remarking on the dollar’s freefall and toying with the idea of moving oil exports to other currencies. The US government’s twin government and trade deficits could push the dollar down to the point that it’s abandoned as the global reserve currency. Foreign central banks aren’t, in theory, going to bother taking on more debt in a debased dollar. Dollar hegemony gives the US the ability to defy fiscal gravity, if this ability is lost then… well, I’m hoping somebody who knows their stuff can tell me what would happen.

    On the other hand, since countries like China know that dumping American debt could ruin the markets that they depend on, they might not be willing to risk it. To me it looks like a very mysterious game, a sort of international prisoners’ dilemma between bond issuers and debt holders.

  2. $455000 per household eh? Perhaps the Chinese could forclose and auction their McMansions and plasmas to get some of their sweat back?

  3. It seems the US subprime problem reaches further than it should because of the failure of the ratings agencies.

    Once upon a time if you held a mortgage with a certain rating you received an interest rate that reflected that rating. AA rated mortgages were less risky than B- mortgages so consequently B- paid a higher rate of interest than AA (I am making up the ratings – I am not an economist or finance guy).

    Then some bright spark realized that if you had a basket of mortgages you could slice them up to create securities (“Collateralized Debt Obligations” or CDOs) with different risk profiles (ratings) and hence different yields (interest rates) than the underlying mortgages.

    To make things concrete, suppose I have 100 subprime mortgages in my basket, with say a default risk of one per year (1%), yielding a long-term return of 10% (subprime borrowers are risky so they have to pay higher interest rates).

    Now, there are two big customers who would like to buy my mortgages off me but can’t because their risk/yield profile is wrong for their investment strategy. The first, “Big Swinging Dick Global Hedge Fund A”, or BSDa for short, needs a yield of at least 20% to keep their investors happy. The second, “Deutsche Pension”, are forbidden by their strategy from investing in less that AAA securities.

    So I get clever with my basket of mortgages. I create a new “derivative” security that makes the holder responsible for losses associated with the first 20 defaults in my basket. I create a second security that is essentially the complement of the first: it continues to pay interest at the same rate until 20 mortgages have defaulted.

    The second derivative is so much less risky than the original mortgages (what’s the chance of 20 mortgages defaulting when the underlying rate is one per year? Almost nothing), the ratings agency grant it a AAA rating, and Deutsche Pension buys it.

    Of course, the first derivative is now far more risky than the underlying mortgages, so it needs a higher yield. To pay for this, I reduce the interest payable on Deutsche Pension’s security (which after all is now AAA), and pay that money instead to the holder of first derivative, which now yields 20%, and is snapped up by BSDa.

    Presto! Everyone is happy.

    The problem with this scenario is that it assumes defaults are independent events. In normal times they are, since they are usually linked to personal circumstances (eg, I default because I fall ill and can’t work). But most subprime mortgages have an inbuilt correlation: they start out with lower introductory rates that reset in a year or two. When they reset, there are a fraction of borrowers who will be unable to meet their obligations, and hence will default.

    Furthermore, in the US where mortgages are “no-recourse” meaning the bank is left holding any difference between the value of the house and the value of the mortage (ie negative equity is the bank’s problem), the subprime borrowers that all reset and default at the same time will also all be underwater on their loans at the same time.

    Thus, the risk profiles of the two derivative securities I created are very different: the probably of 20 defaulting at the same time and being underwater on the loans is now significant, so that BSDa in fact has a high probability of losing all its money; and the probability that more than 20 will default and hence put Deutsche Pension underwater is also significant, making a mockery of the AAA rating for their security.

    This is why the first to fail were hedge funds (a few months ago), and now you are seeing Banks and big pension funds in trouble.

    The bailout announced by Bush is exactly the wrong thing for the mortgagees: it freezes the lower interest rate for subprime borrowers for another five years. But houses are continuing to fall in price, so if you are underwater today you’ll be underwater in 5 years time. Given the no-recourse nature of the loans, you’d be better off foreclosing today, moving into a cheaper house, and letting your bank (or Deutsche Pension, or BSDa) deal with the mess.

    But the bailout does help the investors, because it puts off the day of reckoning, which gives them a chance to unload their securities to a greater fool.

  4. Yes Gerard, all very disturbing.

    But the truly gargantuan figures that the GAO quotes regarding indebtedness of the US government are the products of agreements between consenting parties.

    That is, the Fed on behalf of the US government issued paper signifying this debt and purchasers both domestic and foreign constented to buy this paper.

    On behalf of the US people the US government has decided that the benefits that they will receive from funding the operations of the US government in this way outweigh both funding these operations by taxation or not embarking on these operations at all.

    Now, this may be a crassly stupid decision, but these transactions are conducted quite transparently in the full gaze of media and political scrutiny. The roblem you outline arises when people perceive that the US government isn’t raising sufficient revenue to service these debts.

    On the other hand, the decision of the British government to assume the risk of private investors in Northern Rock represents a stealthy and panic-stricken commitment of public funds.

    BTW, the US government is doing something similar by underwriting the potential losses that may accrue to the Federa Reserve as a result of transactions conducted under the very rcently instituted emergency Term Auction Facility.


  5. The problem with this scenario is that it assumes defaults are independent events. In normal times they are, since they are usually linked to personal circumstances (eg, I default because I fall ill and can’t work). But most subprime mortgages have an inbuilt correlation: they start out with lower introductory rates that reset in a year or two. When they reset, there are a fraction of borrowers who will be unable to meet their obligations, and hence will default.

    Yes. Nice explanation Mugwump.

    I’d only add that one of the reasons why these defaults aren’t independent events is the original motivation for inventing the CDOs you discuss.

    CDOs are a means of securitizing mortgages. In other words the bank originating these mortgages no longer has these mortgages as a liability on its books.

    By selling the risk, the bank has earned the originating fees and has made a profit on selling their mortgages.

    Cleaning out its liabilities in this way allows the bank to originate new mortgages. Eventually, however, banks scraped the bottom of the barrel of people who could afford to buy a house. At this point banks came up with these subprime mortgages as an instrument that provided the temporary illusion that a bellhop could afford a McMansion.

    If the originating bank had to carry such a mortgage on its books the bellhop would have been chucked out of the bank neck and crop. However, because the bank had already estabished the practice of securitization, it could sell the bellhop’s dodgy mortgage to an investor.

    Thus, the practice of securitization allowed for an erosion of the quality of borrowers who were granted finance.

    And as Mugwump says, the inattention of the rating agencies allowed this problem to become a contagion.

  6. Thanks for that link Gerard. I’m assuming this was a joke:

    I don’t see anybody mentioning the Bush Administration in any of this, so maybe it’s not as bad as it sounds.

    If it’s not a joke, it’s laughably wishful thinking. When Bush took office, the people of the USA handed the keys of power over to the Corporatocracy for good. The real movers and shakers in the money markets are no longer constrained by national boundaries, and the US economy is a big, fat, juicy Cash Cow which can be endlessly sliced and diced.

    I’m hoping somebody who knows their stuff can tell me what would happen.

    Exactly the problem, innit? Those who “know their stuff” are busy raking in money hand over fist, as secretively and stealthily as they can, leaving even the supposed “experts” in the dark.

    Prof Q and colleagues have “no idea” how bad things might be, but I’m guessing Dick Cheney, David Rubenstein, and King Abdullah have some idea.

    Of course, it depends how you define “bad”… We wouldn’t want to fall into the trap of making moral judgements, would we? That way lies madness.

  7. The blame game is on!
    I now at least know what a derivitive is, even if I can’t spell it.
    The warnings have been there for as long as?
    To the average punter economic jargon is at fault, keeping the unwashed in the dark with jargon has become a profession.

  8. If you read some of Professor Schillers work on the pyschology of decision making and information assessment amongst the so-called financial luminaries you soon realise that the so-called informed investor is mostly myth. Any form of predicitive assessment is not much better than toss of the coin (probability) plus game theory mixed in for good measure. A little bit of informed intuitive assessment would probably do better if you care to do the research. Given the various ‘interests’ that produce the rubbish that is a lot of financial reporting these days who would not be surprised they never see anything coming.

  9. Morgan Stanley to Sell Stake to China Amid Loss

    Morgan Stanley posted its first quarterly loss ever on Wednesday after taking an additional $5.7 billion write-down related to subprime mortgages. The investment bank said it would sell a $5 billion stake to the China Investment Corporation, that country’s sovereign wealth fund, to shore up its capital.

    The sale, which would give China about a 9.9 percent stake in one of Wall Street’s biggest investment banks, is the latest example of a foreign investor shoring up a Western financial firm in the wake of the housing meltdown…

  10. Yes, Gerard, this has been happening quite a lot recently. Suddenly it’s ok for ragheads and commos to buy up large chunks of the world’s largest finance houses.

    Consider the irony. The world’s communist great power has a powreful voice on the board of the icon of private finance capitalism.

    Remember recently when the great and the good in US public life had a brain explosion when a Gulf state corporation had the temerity to attempt to purchase some US port facilities? What a difference a year makes!

    The interesting question is which party will change its behaviour and strategic goals more: the Communist Party that now pulls strings in one of the most powerful boardrooms in the world, or the US political elites who must now choose between geopolitics and financial stability.

  11. It’s strange, for years I’ve been saying the US was borrowing too much from abroad and was probably going to experience a run on the dollar. I’ve also been arguing that asset markets in the US = particularly bonds and real estate were overvalued and showed all the classic traits of a bubble.

    A year of so back (maybe it was less) John reversed his previous position and started to ask if the US budget and current account deficits were really as bad as they appeared.

    Now I have enormous respect for John as an economist and this caused me quite a lot of headscratching but ultimately I concluded he was mistaken.

    Now, having been out of step with majority opinion in predicting economic trouble ahead for the US, I found myself still in the minority.

    Maybe I’m just a contrary bastard?

    People are speaking here as if they expect the world economy to melt down entirely.

    I think that’s vastly unlikely.

    Anyone remember the 87 crash; the Asian financial crisis; the recession of 91-92; the tech wreck?

    Some people will lose their jobs. Some will lose their houses. Taxpayers will end up financing bail-outs, some of them of firms which don’t deserve or don;t need public money.

    All that is regrettable. It’s also a valid reason for anger since much of the pain is unnecessary and a direct product of the policies of the Bush administration.

    But 10 years from now, most people won’t even remember any of it. (Meaning we’ll probably end up with another borrow-and-spend Republican administration ready to repeat Bush’s mistakes – joy!)

    Meanwhile Centro shares are up from 80.5 cents three days ago to $1.12. As usual people who keep their nerve and invest countercyclically are going to make a packet.

  12. But 10 years from now, most people won’t even remember any of it. (Meaning we’ll probably end up with another borrow-and-spend Republican administration ready to repeat Bush’s mistakes – joy!)

    IG, the inescapable fact about ownership is that people don’t have to remember the moment of transfer of ownership. Title proves that moment of transfer.

    He who pays the piper calls the tune.

  13. Meanwhile Centro shares are up from 80.5 cents three days ago to $1.12. As usual people who keep their nerve and invest countercyclically are going to make a packet.

    Or it’s just the dead cat bouncing.

    I would want to know a lot more about the internal financial condition of Centro before buying those shares. I speak as one who lost money on One-Tel, Worldcom, Enron and Tyco, all of which looked like deals when they were beaten down, had their dead-cat moment, and then went to zero (well, Tyco didn’t go all the way, but I still lost money).

    I don’t invest in individual stocks anymore.

  14. One of the responses to the physical tsunami in SEA was to improve monitoring instruments. Nothing of this kind has happened in the turbulent world of finance – notwithstanding the ever more elaborate regulatory measures by the BIS.

    Securitisation, including the construction of ‘synthetic securities’ (‘derivatives’) is seen as a problem. Yes, it is a problem if one adheres to the habit of trying to measure ‘money’ within the accounting framework (‘Assets’ and ‘Liabilities’) and persists with ranking agencies, which in turn rely on accounting data. The relevant information about the actual financial markets cannot be represented by accounting data because its framework allows only for two forms of finance: equity and risk free debt. Of course, everybody knows that the debt recorded is not risk free. But nobody can tell me why people are interested in balance sheets, other than for fiduciary reasons.

  15. China interests buy into US banking – as Marx once said, ‘capitalists would sell the rope with which to hang themselves’. Arabic interests buy into US banking – so much for the war on terror. Now you know how really know what a desperate state the US banking system really is in. No loss to foreign interests they have to do something with those massive accumulations of US$ for oil and other trade goods, which continue to steadily fall in exchange value, might as well buy a worthless bank with it.

  16. Anyone remember how the Japanese were buying up the US (and Australia)back in the 1980’s and it was the end of US power and the start of the inevitable rise of Japan?

    Current stories about China taking over are probably as exaggerated.

  17. IG,

    I, for one, didn’t suggest that China, or anyone else, would “take over”.

    Indeed, my question was very even handed, concerning which parties would be changed more by the experience of a new source of equity and control of finance houses of the West.

    Unless you wish to argue that there is some sort of identity between the traditional controllers of a bank like Morgan Stanley and “American power”, the suggestion that a change of voice on the board of Morgan Stanley influences “American power”, (i.e., the authority of the government on the United States) doesn’t make a lot of sense.

    Here are some likely changes:

    1. Chinese interests will repatriate profits to China, just like US interests did when US investment dominated the world.

    2. If the Chinese imput is more intelligent than the interests they replaced on the Board, then the US government may enjoy a greater tax flow from a more profitable company.

    However, we have already seen that nativist tendencies are sometimes not far below the surface in American public life. I’m fascinated by how little heart-burning there has been over the Chinese investment in Morgan Stanley compared with the above-mentioned furore over Arab ownership of some US ports.

  18. The US ports issue was one of security, given 9/11 and the possibility of a nuke or dirty bomb rolling up in a shipping container. That said, it was probably safer to have Dubai Ports involved, since the UAE has clearly been off limits to AQ and Co, with those orders coming down from Arab oil street. It’s why the likes of Halliburton set up base in Dubai, because they understand the implicit safety of doing so.

  19. A moment’s reflection would indicate that the owner of a port has no control over the surreptitious contents of shipping containers passing through its facility.

    That role falls to law enforcement authorities.

    No, the ports furore was driven by panic-stricken nativism and by opportunistic pandering to racism.

  20. You know we CAN’T be in a financial crisis yet – we haven’t found a single guy to represent the whole mess yet.

    I wonder who’ll be cast in the Michael Milken/Ken Lay role?

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