Bloody hell, I did not see this coming. Bank of America has bought the 94-year-old brokerage, Merrill Lynch, for a cool $50 billion after the latter firm got hammered by worries about its ability to sustain huge losses. Meanwhile, the investment bank Lehman Brothers, one of the veterans of Wall Street’s banking sector, has gone bankrupt. I know a lot of people who work for both places. I imagine that the atmsophere is grim.
About the best that can be said about all this is that at least the Fed, or the US taxpayer, have not been asked this time to ride to the rescue, as was partly the case with the purchase of Bear Stearns by JPMorgan, as that deal was underwritten by guarantees by the Fed. At last, it has dawned on policymakers that hurling more public funds into the black hole of the current financial mess merely prolongs the agony; it does not end it. That, of course, is zero consolation to the thousands of people who will lose their jobs from these institutions.
This may be the “dark that comes before the dawn”, but it will not feel like that if you are close to the action. I just hope that politicians resist the urge to lock the door after the horse has bolted by imposing new reams of pointless legislation. We have already had endless efforts by central bankers and other luminaries to impose capital requirements on banks through what is known as the Basel process, and a fat lot of good that has done. What is pretty clear from my own vantage point is that we are seeing the culmination of a credit and asset price bubble that has burst very nastily. Relearning the merits of sound money is going to be painful.
A point for the economists to ponder over is whether the use of complex financial products like derivatives have concentrated the risks of financial collapses or made it easier to spread those risks around, so that although there is pain, it is not lethal to an entire economy. I incline to the latter view.
What’s mournful is that they need to be re-learned at all. Where did everyone seem to get the notion that they could throw away all the old rules, and make up new ones without consequence? Did they think that we had them for no reason? Tell me that it was Clinton’s insistence that we had a “new economy”; the old one was all gone, and the new one was totally different. It’s what I want to hear.
Actually I have not doubt the Treasury was asked to bail out Lehman. They just didn’t do it. My God! How could that happen?
Lehman perhaps didn’t have the right connections. I understand their Chairman was exceptionally stubborn and insisted that no problem existed until it was too late to build alliances.
Be that as it may. In the morning we will know if Lehman files for liquidation or for reorganization.
I hope the bankruptcy court applies some very tough love and prevents lawyers and executives from milking whatever millions are left from the corpse.
Nobody will “relearn the benefits of sound money”. Once this mess is over, we’ll do it all over again.
The markets will sort themselves out in time.
This collapse does bring into question precisely what sort of efficacy bailing out Fanny and Freddy possessed. You can try and prop-up failing institutions with the Taxpayer’s money but it won’t cure the disease.
The banking sector needed this: no safetynet, nothing except Chapter 11’s cold embrace. You make silly mistakes, you go under, just like everyone else.
Heck the entire premise behind the Banking sector is to have financial bodies who act prudently to underwrite acceptable risks taken by other entities.
When the banks start acting irresponsibly, they can’t expect to look over their shoulder for someone to prop them up.
I know a lot of people who are going to have their jobs affected by this (thankfully none who worked at Lehman) and I’m sorry for them but the market understands what it wants from Banks and it has demonstrated precisely how it will treat those institutions who won’t or can’t provide that.
I may be wrong but I suspect that the system is going to survive just as it survived all the other shocks. However Fannie and Freddie like the other institutions that date back to the New are going the have to be carefully reexamined.
F & F were typical government instituitions pretending to be private ones. How else could Bill Clinton have packed them full of his cronies? This chould be a warning about the dangers of Public/ Private Partnerships.
I agree with Mr. Swaine. If the politicians can resist their natural urge to “do something” (i.e, throw taxpayers money around and demand more pointless and ineffectual regulations) the market will sort this out. It always does.
As to why this lesson needs to be re-learned: We go through something like this once a generation. It’s inevitable (although some cycles are worse than others). Wall Street is primarily a young man’s game. Young hotshots fresh out of Business school do some large deals, make a lot of money early, and think they are smarter than everyone who came before. They make it to the ranks of upper management without ever having gone through a down cycle, and tend to ignore the warnings of those who have. “The world (and/or market) is different today” is their reply, and there’s just enough truth in that statement to make it plausible, until the next crash.
We tend to think of “The Market” as some monolothic, mechanistic super-human institution. In reality, it’s just people: ordinary, fallible, egocentric and driven by their personal passions. We’re living through historical events. Every generation does.
Bad money drives out good money
With the advent of universally accepted fiat currencies, the debasement of intrinsic value of specie, substantially all the functions of “money” are performed by credit.
By analogy and correlation, we might expect that:
Bad credit drives out good credit
A principal criterion of good credit is the perceived certainty of (i) the future or continuing relative utility of specific assets (tangible & intangible) and (ii) future and continuing value of services (incomes) or of power to extract the value of services (taxes).
The degree of accuracy of perceived “certainties” is designated risk. It is in those perceptions that the Investmnet Banking operations (not its subsidiary businesses) of Lehman malfunctioned.
The dissolution of the boundaries between commercial banking and investment banking (and the related retail [brokerage] functions of the latter) set in motion the consolidations and combinations that will result in different methods of services provision that may be more quickly responsive to the expanding and more direct public participation in the related economic functions.
The idea of a world run by a few thousand financial ‘wizards’ sitting in shiny office blocks in New York, London and Tokyo was always going to be a short term thing. It’s had its day.
This situation is going to get a whole lot worse before it gets better. I love the spin doctors who say that this is “the bottom”. That’s exactly what they said after Bear Stearns debacle, and now we see that the situation has gotten much worse.
Now is the time to promote the ideas of sound money, and true free markets. If that message isn’t shouted from the rooftops now, the socialists will win out when it comes to to rebuild the market.
I was at my GP’s today, getting the last of the jabs needed for the medical for my green card. She proceeded to tell me how the whole Fannie & Freddie debacle was “because they gave so many sub-prime loans”.
My explanation that F&F were not themselves retail lenders, in any event, primarily (entirely?) bought “A” grade paper and their share price was heading back up when the (arguably unneccessary, even by big govt interventionist standards) nationalisation took place was met with a blank stare.
And that’s when it hit me. It was paedophiles! They knew Sarah’s Law was going to be announced, so a shadowy international group of nonces engineered the entire “credit crunch” as a means of subverting it. Even now, they’re partying – “So you know where we live,” they crow, “we’ve seen to it that you’ll never get a mortgage to move away!”
Somone talked about it in March
“Not for nothing, but I wouldn’t be investing a lot of my retirement account with Lehman right now.”
http://www.theamericanscene.com/2008/03/17/picking-up-nickels-in-front-of-a-steamroller
Just like to point out that a lot of that ‘A Grade’ (AAA, you mean) paper that the FM twins bought were actually AAA rated CDOs containing the poisonous mix of good, bad and subprime loans that are the root of this whole issue.
How come S&P and Moodys rated these things as AAA grade when they contained what they did is the real question people should be asking – if they weren’t rated AAA by those guys then no-one would have bought them and none of the reinsurers would have reinsured them – and the crisis would have been stuck firmly with the idiots that created them.
You may wish to consider that they were also only created by the mortgage issuers as a way to shift loans they only made because the US government ordered (through a variety of laws designed to ‘make it easier for people to own houses’) them to lend money to boost the subprime market – as all the ‘prime’ borrowers were already fully indebted.
That’s the short version, FYI.
How come S&P and Moodys rated these things as AAA grade when they contained what they did is the real question people should be asking
That’s actually pretty easy. They looked at the historical default rates on Mortgage paper and saw that they were very low. Therefore Mortgage Paper was a AAA risk regardless of what the loan was.
As there was no historical precedent for lending outrageous sums to people with no income, the caca didn’t start to fly fanward until these loans passed their low start points and the defaults started flying.
It’s a fairly classic example of extrapolating on past trends when you’ve dramatically altered the original conditions.
I read somewhere else that the last sets of bad paper are not due to hit the major default conditions until around March 2009, so there’s probably more to come until we have this worked out of the economy. There’s an excellent graph over on Space Cynics showing the rates of Home Repossessions in the USA. It’s not a pretty one.
The question really is what to do about that and the banking sector. Common sense should let over extended brokerages and banks fail and get picked up for a song by their saner/luckier competitors. What do about 100,000 homes dumping and the effect on clusters of house prices is harder to say. I want to buy a second place next year but with the best will in the world, the prices around my part of WA aren’t going to drop all that much, even if WaMu fails. Holiday mansion in Las Vegas anybody?
Anonymous is correct, but only to a point. I certainly don’t want to make apologies for the rating agencies, because I agree that they deserve far more of the blame for the whole mortgage mess than they’ve gotten so far (and they’ve gotten a lot). Still, simply including “subprime” loans in a pool doesn’t automatically make the securities less than “AAA” grade, as Anonymous seems to be asserting.
Most subprime borrowers actually make their payments; it’s just that a higher percentage of them tend to make the payments late (which translates into higher servicing costs) and/or actually default on their loans (which translates into foreclosures and liquidation losses). As long as you forecast the delinquency and default rates reasonably accurately, you can put enough “credit enhancements” (subordinated tranches, principal “turbo” features, bond insurance, etc.) into the deal structure to legitimately warrant a “AAA” grade. The problem, as Daveon correctly pointed out, is that the rating agencies and the bond insurers (which no one has yet mentioned) failed to accurately (or even, I would posit, intelligently) account for the explosion in low- and no-doc loans, higher loan-to-value ratios, lower credit scores, unsustainable property appreciation rates, and (especially!) those brain-dead “pay-option ARM” loans. They were in uncharted territory and failed to understand it. In the case of insured bonds it is really those insurers who are most at fault; the rating agencies essentially (and, for the most part, reasonably) applied the claims-paying ratings of the insurers to the bonds, since it is the insurers who are “on the hook” for any losses ultimately suffered by investors.
I wouldn’t be buying stock in any of those monoline insurers right now; they have some large claims looming on the horizon.
To see why derivatives were a curse, and indeed, how and why they became such a curse, you really need to know only two things:
1. The amount of off-balance sheet swaps/options etc were equivalent to about 19x total bank credit.
2. Every investment bank derivatives desk around the world claimed to be making money, even though their main customers were only ever each other.
The only way to square these two observations is to realize that they were at best a series of transactions designed to (legitimately) exploit international regulatory, accounting and tax arbitrage opportunities.
And this was simply the result of the globalization of capital flows happening faster than the globalization of regulatory standards. To avoid this particular accident happening again, we don’t need more regulation, we need consistent regulation, and consistent market infrastructures.
Alternatively, and far more sensibly, we could simply abolish commercial banks (and their offspring) altogether – they are, after all, an 18th century technology inappropriately souped up with 21st century firepower.
Laird/Daveon, thanks for that – that nicely rounds off my ‘the credit crunch in three paragraphs’ that I’ve been trying to put together, as I’ve had to explain it about a million times so far.
I vaguely mentioned the reinsurers – it seems to me that they made exactly the same faulty judgements as the bond raters, which seems a bit odd.
Is that _really_ how it’s done?!
Daveon
Under the Community Reinvestment Act (passed a long time ago – under President Carter) not lending in a poor area (i.e. to people with little income who are unlikely to pay you back) lays companies upon to being sued.
And organizations like ACORN have been using this power for some years.
Of course that does not mean the financial sector companies had to get this no-hope subprime debt and and play complex games with it (thus making the burden much bigger and spreading it to enterprises who are not directly involved in such places as the south side of Chicago), but there were go.
The root of the problem is the massive increase in credit/money by the Federal Reserve (the old game of trying to produce money for lending out that is not 100% from real savings).
As for “sound money”.
The Supreme Court ripped up the Constitution on that matter in two judgements back in 1935 (indeed the Second Greenback Case back in the 19th century should also be noted).
But today we (neither America or Britain) have even fiat money.
In fact the fiat notes and coins only make up a small fraction of the money supply – the rest is pure credit bubble, and a credit bubble that has to go somewhere.
Certainly playing with regulations (such as restoring the divide between investment banking and retail banking) is not going to deal with this issue.
But if it makes people happy……..
I should have typed “we do not even have just fiat money”.
It would be bad enough if the money supply was made up of fiat notes and coins that only have value because of government legal tender laws and demands that taxes be paid in them.
But the present situation is much worse than that.
Much of the money supply is not even fiat notes and coins – as I said it is pure credit bubble.
Credit bubbles have gone pop before without destroying the economy.
For example the World War I credit bubble went pop in 1921 and the economy was in recovery in six months.
But modern government is very different from the “corrupt”, “stupid” Warren Harding.
Modern government (from Herbert The Forgotten Progressive Hoover onwards) will try to “help” – for example by trying to prop up wages so that the labour market does not clear (and by many other insane moves).
As Ludwig Von Mises said back in the early 1920’s (observing European governments) this is not even proper Marxism – if is “Destructionism”.
I should have typed “we do not even have just fiat money”.
It would be bad enough if the money supply was made up of fiat notes and coins that only have value because of government legal tender laws and demands that taxes be paid in them.
But the present situation is much worse than that.
Much of the money supply is not even fiat notes and coins – as I said it is pure credit bubble.
Credit bubbles have gone pop before without destroying the economy.
For example the World War I credit bubble went pop in 1921 and the economy was in recovery in six months.
But modern government is very different from the “corrupt”, “stupid” Warren Harding.
Modern government (from Herbert The Forgotten Progressive Hoover onwards) will try to “help” – for example by trying to prop up wages so that the labour market does not clear (and by many other insane moves).
As Ludwig Von Mises said back in the early 1920’s (observing European governments) this is not even proper Marxism – if is “Destructionism”.
Almost needless to say the Marxists will use the consequences of Destructionism (i.e. government efforts to help over the last few years – and in the future) to try and gain power (after to which they will eliminate what is left of dissenting media and so on, in various ways).
Already the wild spending Bush Administration is being called the most “ultra capitalist” in modern history – the enemy are shameless in their lies. “Capitalism” will be blamed for the Federal Reserve system credit money bubble (and do not hold your breath for that “liberarian” Alan Greenspan to come and say “it was my fault, I have been expanding the bubble for many years”).
Sadly even if we manage to defeat the Marxists in November, they will be back.
Their influence over education (most universities and even schools) and over the things the education system influences (such as the main stream media) is so very strong.
Under the Community Reinvestment Act (passed a long time ago – under President Carter) not lending in a poor area (i.e. to people with little income who are unlikely to pay you back) lays companies upon to being sued….
(snip)
….Of course that does not mean the financial sector companies had to get this no-hope sub prime debt and and play complex games with it (thus making the burden much bigger and spreading it to enterprises who are not directly involved in such places as the south side of Chicago), but there were go.
Paul, even under those acts, the financial institutions were protected by sensible lending practices. Deposit+Credit Rating+Ability to Pay applied equally made for a stable mortgage market.
The kind of loans being seen towards the end, especially in Las Vegas (fastest growing City in the US until last year) were nothing like that. They were nothing down+no deposit+no income.
The lenders could get away with that because at the end of the day they weren’t going to be left holding the mortgage paper and a house worth 60% of the mortgage, on a street of houses the same – something big in Vegas and Miami at the moment.
Paul: Sorry to burst your bubble but Obama isn’t Marxist, and McCain isn’t a real capitalist. And more banks will fail and more regulation will come of this.
Fiat currencies serving part of the functions of money, are not the major part of “money” from the transaction and mensuration accounts.
The fact that currencies and specie are now just forms of credit does have significance.
A primer on “derivatives” will disclose at least two general classifications (i) those based on actual assets and/or [forgive me that transgression] cash-flows and (ii) those about [but NOT on] assets and cash-flows. That has been referred to as “side bet finance.”
Oops, cut myself off:
What happens is a partial “failure” in the based on flushes out much more in the about category. Somewhat similar to abduction in a modern low-flush toilet, where a little input creates a lot of suction and moves a lot of — “credit instruments.”