Financial Advice, pt. 6

This has been a bear of a week.  As much as I have enjoyed coming to an understanding of this book, The Trillion Dollar Meltdown, I have also come to see that the amount of information that plays a part in these financial transactions is almost beyond what one brain can contain.  For one thing, we are a consumer economy but have become an investment dominated culture.  I remember waking up every morning to the sound of CNBC Market Week with Mario Bartiromo, when the commentaters were stars, and the line of ticker tape across the bottom of the screen, in reds and greens, was something we devoured along with every breakfast. 

But back in the early 90’s, in between volleyball games at the beach, I’d be passing the ball back and forth with someone while I could hear in the background these old guys who used to play discussing their Wall Street Journal and wonder WTF.  Since then times have changed and those retirement funds that are playing such a large part in our current story, those are yours and mine.  So get used to it, we share in the responsibility of this emerging disaster.  We have taken the free market ride and this has been our destination all along.

Chapter Six:  The Great Unwinding

Remember the perky little CDOs from chapter four, and the credit swaps that were used to create synthetic CDOs, well they are back in this chapter with a vengence.  As you might recall, the grouped mortgages were sliced horizontally to create tranches of funds with the bottom tier becoming the high risk but very lucrative high yield toxic waste.  The question then was who or what would buy into such an investment?  The answer now becomes clear,

Hedge funds are unregulated investment vehicles that cater to institutions and wealthy individuals, and promise extraordinary returns.

As of mid-2007, hedge funds deployed an estimated $2 trillion to $2.5 trillion of equity capital, and much higher economic capital due to their aggressive use of leverage.

I recall driving out to Vegas while we listened to real estate mogul, Robert Kiyosaki, explain how leverage worked.  Of course, we could buy one property with our $100,000 but wouldn’t it be better to use the money to buy ten properties.  With $10 k down, the banks would lend the OPM to do the rest.  This is the thinking that dominates in the world of finance.  Leverage your money.  Use your tranche of CDOs to credit swap up.  Buy a house for $200,000 in two years sell it for $500,000 use the $300,000 gain to buy a million dollar home.  It all works unless, of course, the market comes tumbling down.  Or you are using a subprime mortgage that resets in 3 yrs at twice the interest rate.  It is after all an immense illusion.   Everything depends on no one noticing that the king is still naked.  And just as million dollar homes aren’t really worth a million so to the CDOs aren’t really worth there original valuation either.

Think of it this way.  Your Wiley Coyote hedge fund is one tiptoe on the ledge and the rest of its body of mortgage liabilities teetoring over the cliff.  All it takes is one slight breeze of interest shifts upward to tip the mark to market balance.  Says Morris,

The hedge funds’ appetite for the riskiest positions has made them a major source of liquidity in the CDO and credit default swap markets.  Their willingness to employ leverage to maximize those positions amplifies their impact.  The funds’ demand for higher-yield products is pushing the industry up the risk ladder into CDOs constructed from second-lien loans, bridge financings, private equity, and other less liquid assets, often with minimal protections for higher tier buyers.

The shift in credit hedge fund investing wawy from cash-flow CDOS toward credit derivatives, Fitch reports, “introduces its own unique risks that have not been fully tested in a credit downturn . . . (and) could foster greater short-term price instability.”

Morris’ walk through of a leverage example on pgs. 111 and 112 shows just how high the ledge really becomes in one of these deals.  5:1 becomes 20:1 becomes 100:1 just like that.  “Now assume the CDO incurs a 3 percent loss.”  The deal value which started at $20 million hedge funds and $80 million bank loans for a total of $100 million is now only worth $40 million.  The hedge fund and bank have to raise another $40 million just to cover their losses.  Think Bear Stearns, which was credit default swapping in billions, then multiply that by the fact that there are 100s of hedge funds and you can see the problem.  Not only is this credit market teetoring and ready to fall but that is us at the base of the cliff waiting to get crushed.

Do you know what a Ponzi scheme is?  You collect money from one set of investors and use it to pay off a second set, then a third set, fourth set, etc, etc, etc.  As long as the money keeps coming in and no one regulates it but yourself, everything will appear to be fine.  But Morris concludes this chapter by referencing Hyman Minsky, “a Keynesian economist who became famous for his theory of financial crises.  Unlike the Chicago-based school of free-market ideologues, Minsky believed that instability and crises were inherent features of financial markets.”  Put a Ponzi scheme of  100’s of hedge funds and real estate subprime loans and credit card debt into his model and you can see where we are heading.  Morris would have us reveal all the deals and face the music but as he notes at the chapter’s end,

The American financial sector today is far more powerful than it was in the 1970’s (when the pendulum swung towards the free-market theory).  And to date, its response to the looming crisis has been, overwhelming, to downplay and to conceal.  That is a path to turning a painful debacle into a decades-long tragedy.

Tomorrow: Chapter 7: Winners and Losers

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