Notes on the crisis
I’m standin’ in the shadows with an aching heart
I’m lookin’ at the world, tear itself apart
— Bob Dylan, “Mississippi”
Here Dylan has given us a brilliant summation of the condition of the simple citizen in the face of the economic crisis that exploded in our faces in mid-September, and which may well prove more momentous than another calamity, another September, seven years earlier.
This thing has had the general characteristics of a Bob Dylan song: a long tale of human squalor and calamity, punctuated by flashes of biting humor and vaguely undergirded by a strange sense of sympathy, even a touch of paradoxical joy.
I can only speak, of course, as the simplest layman, and even that may be too bold. No doubt whatever I say about the crisis will include error, for the world of finance, despite by best efforts, remains to me mind-bogglingly opaque in many respects.
Nevertheless, I feel it is a perfectly defensible statement to say that we have beheld some astonishing sights in these last two months. What follows is a scattershot set of what can only be called notes. The notes of citizen watching the world tear itself apart.
At the height of the crisis in September, I asked a knowledgeable friend to try to explain what he was observing. He groped briefly for a way to convey it, then said, “Imagine you woke up and the sky was green instead of blue.” Another analogy he used was, “What if you looked, and found that the sun was rising in the west?”
We have witnessed Porsche take control of Volkswagen, not by purchasing shares (the old fashioned way), but by purchasing, outside from view, derivatives that force other people to sell VW stock. Disgruntled Europeans took to the papers to denounce the mercenary shrewdness of Porsche, accusing it of behaving like ruthless hedge fund. The charge is not far-fetched: Porsche made substantially more profit exercising options (another company’s options) than it did selling cars.
We saw the world’s biggest insurer, with an empire of sturdy assets, brought to its knees by the weight of some other, even more arcane derivatives. We saw the country of Mexico, a big oil-producer, hedge an entire year’s worth of oil exports against oil, again through the mechanism of financial derivatives. These derivatives, as I understand them, amount to a kind of unregulated market in abstracted risk. Companies and banks and hedge funds buy and sell, not products, not even futures on products, but packages of risk on the profitability (or lack thereof) of products. Mexico paid several investment banks a cool 1.2 billion dollars to assume the downside risk on oil. No product changed hands, only an abstraction of risk.
Everything happening so fast. Recall that for a couple weeks in late September, the Europeans were enjoying a good laugh at our expense: there was giddy talk of the end of American economic hegemony, the resurgence of the European model, and so on — until the crisis vaulted the Atlantic. Now we read that the recession in Germany — a country which wisely avoided the both a housing bubble and an overextension of consumer credit — may well be deeper than the one in America.
The dread word DEFLATION has appeared in newspapers and on the business news channels with appalling regularity of late. It is pretty clear that the bursting of the housing bubble provoked a hysterical flight to commodities, above all oil, which in turn experienced its own rapid and ruinous bubble. Perhaps the only pleasurable thing in this whole mess has been watching the spectacle of OPEC’s pathetic flailing against forces beyond its control.
Now the worry is that fears have driven panicked investors to inflate a new bubble: that of American sovereign debt, which the Federal Reserve has been selling like hotcakes.
Is it possible that we’re in the midst of the death throes of the Globalization project of the last 60 years? The Financial Times reports on how manufacturers with huge globalized supply chains have taken the striking step of encouraging their suppliers to come to them for aid in lieu of the banks when things get tight. Now obviously these manufacturers are not doing this out of the kindness of their hearts. It’s a matter of interest and even necessity. If some link in those supply chains is irrecoverably broken, companies could be ruined in a matter of days.
But the undercurrent of the FT article, as I read it, is that globalization has made even solid, conservatively-financed companies extremely vulnerable, and that they are rethinking Globalization itself. Likewise, it’s probably only a matter of time before someone influential proposes an American sovereign wealth fund. Everybody’s doing it, you know.
Watching this mess, you really do have the feeling that you’re watching the world tear itself apart. The Treasury Department, hoping to save the banking sector that is the lubricant of the whole economy, is shoveling money into the banks with abandon, but (a) the banks are so desperate to deleverage that the money is vanishing as fast as it arrives, and (b) it’s an open question whether anyone out there among consumers is even looking to borrow from them in any aggressive way. Senators, in turn, threaten to “mandate” that the banks start loaning. But only a very strange mandate indeed would insist that they lend money they don’t have to people who don’t want to borrow it.
The whole Republic had a somewhat rancorous debate over the merits of the Troubled Asset Relief Program proposed to Congress back in September by Treasury Secretary Paulson and finally passed with modification in October. Its purpose was ably analogized by my friend Zippy Catholic at another website.
Well, forget about all that. The TARP money is doing different things now, mostly purchasing preferred shares and warrants in banks. In short it’s assisting in the deleveraging of the financial sector.
The picture of Wall Street, stock markets and investment that most of us have grown up with is shattered, probably irretrievably. Someone sent me an email some weeks which made mention of the fact that in the year 2000 the NASDAQ was above 5000. I laughed out loud at that.
But it was hollow laughter.
You watch these developments and your first instinct (if you are, say, me) tends towards outrage. Where is all this flipping money coming from? And just what the hell happens when US sovereign debt is no longer seen as a secure investment by China, Japan, the Gulf states, etc.? Why won’t the bloody banks start lending? What about buying up bad mortgages, Mr. Secretary? — But after a bit of investigation, the enormity of the whole situation hits you, and outrage is replaced by resignation tinged with sympathy. (Glib answers: The banks ain’t lending because no one wants to borrow money, and no one wants to lend it. The TARP transmogrified into a quasi-nationalization program because the opportunity to put a firewall around the bad mortgage-backed securities had passed, and maybe never really existed in the first place. The money is coming from the sale of US debt; and for the time being, everyone and their uncle is racing to protect what wealth they have left in US debt. So we got that going for us, which is nice.)
How long that will last is a rather disconcerting question. No doubt the budget deficit will cross over into the trillions soon. Cities, states, companies, funds — they’re all lined up at the federal dole. Even more disconcerting is real possibility that all this debt-financed expenditure won’t do any good, because banks, countries and individuals, spooked and demoralized, are absorbing it as fast as it arrives and not even thinking of putting it to productive use. A steady contraction in demand is staring us in the face, and it is far from obvious that government spending can arrest it.
We’ve also seen, as our indespensible finance editor Blackhedd has document, some astonishing effects of the crisis on government bond spreads. Negative interest rates and insanities like that. I lend the government money, and pay the government some fractional interest for the efforts.
So you get to a place where criticism is just impotent. I am constitutionally hostile to bailouts. And yet here I sit thinking that maybe letting Lehman Brothers fail, instead of rescuing it, was the decisive mistake. Or not. My criticism is disarmed by circumstance. The best I can do is fumble for some kind of reactive understanding. I’m standing in the shadows with an aching heart.
* * *
The Wall Street Journal featured a fine piece of reporting awhile back aptly headlined, “Anatomy of the Morgan Stanley Panic.” It is well worth reading for anyone seeking insight into how the crisis was precipitated, with specific emphasis on the interaction of short-selling and derivatives.
The article details the panic of mid-September. Back then, like many banks, Morgan Stanley careened toward ruin, propelled by plunging stock value, rapid credit derivative inflation, and a flight of capital by hedge funds. It nearly fell off the cliff, and in the end required state assistance to survive.
Morgan Stanley can probably function as a metonym for investment banking in late modern America. The sector no longer exists on Wall Street, strictly speaking. It fell to the vicissitudes of human psychology, exaggerated and accelerated by the web of abstraction which had been its bread and butter for a decade.
It would be idle to attempt to attempt to summarize the tale told in the Journal. The writers have already done that masterfully. Instead I’ll offer a few snippets, organized briskly.
On Sept. 16, Morgan Stanley’s stock fell sharply during the day, although it rebounded late. Some hedge funds yanked assets from the firm, worried that Morgan might follow Lehman into bankruptcy court, potentially tying up client assets. [. . .] Protection for $10 million of Morgan Stanley debt [that is, credit-default swaps] had risen to $727,900 a year, from $221,000 on September 10. [. . .] It’s impossible to know for sure what was motivating buyers of Morgan Stanley credit-default swaps. The swap buyers stood to receive payments if Morgan Stanley defaulted on bonds and loans. Some buyers, no doubt, owned the firm’s debt and were simply trying to protect themselves against defaults. But swaps were also a good way to speculate for traders who didn’t own the debt. Swap values rise on the fear of default. So traders who believed that fears about Morgan Stanley were likely to intensify could use swaps to try to turn a fast profit.
Amid the uncertainty that Sept. 16, Millennium Partners LP, a hedge fund with $13.5 billion in assets, asked to pull out $800 million of the more than $1 billion of assets it kept at Morgan Stanley, according to people familiar with the withdrawals. Separately, Millennium had also shorted Morgan Stanley’s stock, part of a series of bearish bets on financial firms, said one of these people. In addition, the hedge fund bought “puts,” which gave it the right to sell Morgan shares at a set price in the future.
That same day, Sept. 16, Third Point LLC, a $5 billion hedge-fund firm run by Daniel Loeb, began to move $500 million in assets out of Morgan Stanley. [. . .] Around the same time, hedge fund Owl Creek began asking to withdraw its assets, and ultimately took out more than $1 billion. [. . .] Before noon [on Sept. 17], swaps dealers began quoting the cost of insurance on Morgan in “points upfront” — Wall Street lingo for transactions where buyers must pay at least $1 million upfront, plus an annual premium, to insure $10 million of debt. In Morgan Stanley’s case, some dealers were demanding more than $2 million upfront.
During the day, Merrill bought swaps covering $106.2 million in Morgan Stanley debt, according to the trading documents. King Street bought swaps covering $79.3 million; Deutsche Bank, $50.6 million; Swiss Re, $40 million; Owl Creek, $35.5 million; UBS and Citigroup, $35 million each; Royal Bank of Canada, $33 million; and ACM Global Credit, an investment fund operated by AllianceBernstein Holding, $28 million, according to the documents.
The following day, Sept. 18, some of those same names were back in the market. Merrill bought protection on another $43 million of Morgan Stanley debt; Royal Bank of Canada, $36 million; King Street, $30.7 million; and Citigroup, $20.7 million, the trading records indicate.
And on and on. Keep in mind that (supposing, as always, my understanding of this stuff is accurate) in most of these transactions, no property was changing hands. Short-selling involves borrowing stock and selling it lower, and credit-default swaps involve trading abstracted risk on a company’s failure.
What do I take away from the article? Mostly a kind of staccato of intuitions which I am trying to organize into coherent thoughts.
(1) All this high-finance engineering leaves me adrift, ideologically. Doctrinally speaking, what does Capitalist theory have to say about the possibility that a company may be driven to ruin and disgrace in a matter of days based on panicked hedging and derivatives sales? Does Capitalist doctrine require that Treasury and the Federal Reserve sit idly by and watch the degringolade? Was the SEC wrong to ban short-selling financial stocks on September 18? Was the Fed wrong to backstop money market accounts? I find the answers to these questions, if they issue from doctrinal propositions, rather unsatisfying. My instinct is to favor prudence and pragmatism.
(2) Our subjection to these engineered financial abstractions, so painfully obvious now, will be a long time in unwinding. (Municipal bonds, it seems, are the latest category of security battered by credit-default swap inflation.) There is no doubt in my mind that it needs to happen — the brutal deleveraging, the retreat from credit at all levels, the return of real savings — and that in the end the economy will be healthier for it. But the bitter truth is that even these healthy developments will in all likelihood exacerbate our current agony, for they amount to almost irresistible deflationary pressures.
(3) Right now almost everyone, from consumers to the biggest private bank, is hoarding cash. The Treasury and the Fed have together added to the markets a truly extraordinary sum of money. Bloomberg News came up with a figure of nearly $8 trillion, inclusively of everything since the Bear Stearns bailout in March, whether spent or pledged. This was before last month’s announcement of a new lending facility for various securitized consumer debt, along with the huge purchase of Fannie/Freddie debt.
(4) It could hardly be plainer that Paulson, Bernanke and Geithner regard the deflation fears as all too real. They’re hoping to inflate our way out of it. As a Blackhedd puts it, the helicopters are in the air, dropping money from the sky. We’re even hearing the phrase, “quantitative easing,” which is a rather curious euphemism for directly expanding the money supply. Whether even the enormous resources of these men, and the institutions they lead, can correct the kind of contraction in demand we’re experiencing is an open question.
(5) On the other hand, if the deflation fears are overwrought, then we’ve got a serious inflation problem on the horizon. That is to say, if the contraction in aggregate demand proves temporary — never matures into a deflationary spiral like the Great Depression — then there are literally trillions of extra US dollars floating around out there; and when they begin to flood world markets whenever economic activity resumes, the strength of the dollar will plunge. This will be true even without the expected expenditure of Obama’s Keynesian fiscal measures.
(6) I said above the crisis will be a long time in unwinding. There I meant financially, but it will be even longer for the social effects to be felt. Indeed, there are still plenty of people who think the whole business is a bunch of hooey. The panic is media-driven or something. This, I’m afraid, is a sadly myopic illusion. We might as well say that Hurricane Katrina was media-driven.
In truth the wealth of an entire generation and more of Americans has been laid to waste, and shall not soon be recovered. The lifestyle of philosophical ennui, which reigned over the last decade and more, shall whither. It will be many, many years before standards of living will be restored. An entire generational mentality about equity investment will similarly perish.
To round out this formless sketch I’ll tell a little story or parable. This year’s Wake Forest University basketball team, it turns out, shows real potential for the future, boasting a host of agile big men with enormous range and talent, along with several tough guards. They are very young, and need to shoot the ball better to really compete against the powers of the Atlantic Coast Conference, but there is certainly potential in this team.
Ten years ago on this day, when your humble correspondent was a student at Wake Forest, there was also a good basketball team. But more importantly there was an extraordinary boom of wealth generation in the stock market, felt even down to the stunted mind of the rowdy and reckless boy your humble correspondent was back then. The image of this wealth filled the American imagination.
But then the tech bubble bursting gave way to the mortgage bubble, which burst in time to fuel the commodities bubble. Until this very fall, the whole mentality begun in around 1994 (or even earlier if you consider Clinton the consolidator of Reagan), the notion that the stock market (or, later, housing values) would gain infinitely and enrich everyone, was operating in force.
I doubt it will survive this, that mentality. The end will be a long time in coming, but come it will. And one day the historians will say that in the Autumn of 2008 a world died.