Tuesday, October 07, 2008

Wall Street's failure and Credit Default Swaps explained - and the future guessed at

Calculated Risk offers a video from "60 Minutes" in which Steve Kroft explains the mortgage crisis, credit crisis, and now the financial melt down on Wall Street and overseas. The key to it is Credit Default Swaps.

There is a short advertisement before the video starts. The video is worth sitting through the advertisement.


Watch CBS Videos Online


This is background information. It does not explain what the bail out legislation is supposed to do to solve the problem. Nor does it explain what the problem is with banks now refusing to lend money to borrowers and especially to other banks. For an explanation of the current problem in which banks are now refusing to lend to anyone, Robert Reich offers as good an explanation as I have seen recently in his recent blog entitled "The Meltdown (Part I)".
Global capital markets have seized up. Confidence is evaporating. Put simply, no lender trusts any borrower to repay, fearing that that borrower won't be able to rely on anyone else to honor obligations. Even banks are hoarding cash, unwilling to lend to other banks. Everyone with any savings is heading for the hills -- for gold, for under the mattress, for wherever savings can be watched. We're witnessing a huge international bank run. We have not seen a global financial crisis on this scale since the 1930s.

What's happened? Put simply, the Bailout of All Bailouts has been a dud, at least so far. Most obviously, it hasn't done what it was intended to do -- reassure financial markets that the Treasury and the Fed would have enough money to handle any financial crisis.

So it's everyone and every institution -- and every country -- for itself. Several nations (Ireland, Greece, Germany) have basically guaranteed all deposits. As a result, global capital is moving their way. They're also thereby creating a new form of socialized capitalism. At the rate they're going, these nations will soon own and run their financial markets, and maybe a big chunk of the world's.

I fault Hank Paulson, first and foremost. He never succeeded in explaining to anyone what exactly he'll do with the bailout money -- how, for example, an auction to acquire mortgage-backed bad debt would work, and whether and to what extent he's planning to recapitalize the banking system. Even now, the American public has no idea what he's up to. Nor, for that matter, do many insiders.

Leadership isn't just about passing a big piece of legislation. It's about explaining and thereby gaining trust and confidence from a public -- including a global public -- that's otherwise afraid and confused. A credible and powerful explanation is necessary right now -- about where we've been, how we got into this mess, and how a particular plan (in this case, the bailout), will get us out of it. Yet Paulson has proven himself uniquely unable to explain anything to anyone. George W. Bush, for his part, is hopeless and hapless. Worse than a lame duck, he's a seriously disabled parakeet, with no remaining store of public trust. Ben Bernanke seems like an able fellow but his capacity to communicate is almost as bad as his predecessor's. Congressional leaders are too busy pointing fingers of blame to be capable of explaining much of anything and summoning confidence. And fewer than three weeks before a national election, both candidates are inevitably caught up in partisan wrangling. Obama does understand what's happening, and could calm global capital markets if he were already president. But he is not president as yet, nor even president-elect.

The leadership vacuum could not happen at a worse time. If credit markets remain frozen, we'll soon witness a huge round of business bankruptcies. We're in completely uncharted terrain.
So what happens next?

That's what "completely uncharted terrain" means. No one knows. But a good guess would start with assuming that economic conditions are going to rapidly get worse between now and the Presidential election on November 4th.

After that?

The problem right now is that no one knows what will happen next, and the current political and financial leadership are all fighting each other for individual advantage. There is no established leader who anyone trusts. Bush, for example, refused to even recognize the housing bubble until recently and when the Paulson Proposal was developed overnight and handed to Congress like the hot potato it was, Bush's name couldn't even be placed on it. The generally unknown Paulson was a much better name to apply to the sales job. And Paulson has also demonstrated no political leadership.

Without leadership, the trust the bankers need to start lending again will not be recreated. The House conservative Republicans who killed the first effort to pass the Paulson Proposal (as directed by Newt Gingrich, in the name of saving the "Free Market" on Wall Street) similarly have no clue. They are fighting to retain the power they have had since Gingrich led the conservative Republican takeover of the House in 1994.

But they are fighting to retain their power and the ability to enforce their ideology, with no regard to what happens to America. That's what happens when a corrupt leadership faces a new threat to the nation. The scrap over power instead of working to solve the problems.

Brad DeLong said last week or so that the problems America face will not be solved until the Republican party is gone. The conservative Republican party needs to be buried, the ground they are buried in needs to be plowed under, and the ground needs to be salted so that they cannot grow back.

I agree with him. The conservative ideology is totally incapable of dealing with the current economic crisis, and the conservatives will continue to obstruct effective actions as long as they are allowed to remain in the government.

After that? Let's hope that the new President can provide some effective leadership quickly - and McCain does not have that capability as the current disastrous condition of his Presidential campaign clearly shows.

We'll have a decent idea what's going to happen by New Year's, I think. But the Recession will last at least the next two years. Beyond that? No telling.

1 comment:

Richard said...

The difference between CDS and PMI is that mortgage insurance (PMI) is regulated as insurance, to be issued only by companies with sufficient capital to pay off if the mortgage-holder defaults, even if a large number of mortgage-holders all default at once.

CDS are called swaps instead of insurance specifically to avoid the regulation that selling insurance requires. The result it that a great number of issuers of CDS are not sufficiently capitalized to handle sharp downturns in the economy.

Issuers of PMI must publish financial statements showing their reserves that permit them to pay off when required. Sellers of CDS have no such requirement. The have often been sold by large corporations like AIG which are so very large and successful that they could never fail. (Oops!) That absence of published financial statements showing reserves to back the CDS also means that no one knows just how much of the economy is supposedly secure because someone bought CDS. The level of systemic risk is simply unknown.

Banks cannot properly price financial instruments when risk is unknown. That means financial markets don't work.

Other than meeting regulations that are designed to ensure that the issuer of the swap/insurance will be able to pay off what they promised when required, you are correct. CDS and PMI are the same thing. CDS are just low quality unreliable untrustworthy PMI.