Finding Spare Change for the Invisible Hand

Second in a series of web-only articles on the subprime/securitization crisis.

Larry Peterson

This is a web-only article is from Dollars & Sense: The Magazine of Economic Justice available at

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Since our first piece on the subprime/securitization crisis came out, we've seen official proposals to confine the damage come and go, with price tags going up each time, while the contagion itself continues to infect regions of the financial world most people never even knew existed. As we noted in December, whisperings about the bond insurers (or "monolines," about which more in a moment) were beginning to surface; and, surely enough, those fears have not only materialized: indeed, the sector may now constitute perhaps the major weak spot in the entire financial system. Back then, all the talk was of a "Superfund," or Master Liquidity Enhancement Conduit, amounting to some $100 billion, that would maintain demand for quality investments in the face of widespread risk-aversion; now, losses from the crisis already top $150 billion, and important credit markets remain just as glutted as before—and that in spite of historically unprecedented monetary injections by the Federal Reserve. In addition, lest we forget, the banks continue to revise their estimates of subprime-related losses wildly upwards. Finally, the macroeconomic affects of the crisis are now plain: negative job growth in January, GDP growth a whisker above zero for the fourth-quarter of 2007 (which may be revised downwards into negative territory), productivity decelerating: but with inflation rising to levels reminiscent of another economic era.

First, let's review market developments since our last article. December saw another quarter-point interest rate cut by the Fed, bringing the key Federal Funds rate down to 4.25% from its high of 5.25% just before the Summer crash. The Fed's strategy here was to ensure that banks had enough money to meet all their obligations for 2007. In this, they were successful, but continued revisions of loan losses and profit writedowns by the banks prevented the kind of upswing in credit market activity the Fed was hoping would kick-start the financial sector—and the whole economy—out of its funk. Meanwhile, the Superfund idea was dropped (due to lack of interest by the participating banks), and the emphasis shifted to providing banks with the option of bidding for emergency funds in auctions (rather than going to the Fed's "discount window," which, besides requiring payment of a—rapidly diminishing—penalty, carries a stigma for the banks, and may thereby discourage depositors). At the same time, Sovereign Wealth Funds continued to pour funds into troubled firms' coffers. But economic activity began to show signs of serious contraction: in particular, Christmas retail sales were poor, and housing starts dropped sharply. The markets began, once again, to factor in another big interest rate cut.

They got what they wanted in January, but in a manner that still gives fund managers a case of the heebie-jeebies. And here's where the monoline bond insurers dropped in on the scene with a great big bang. As their name suggests, the monolines (like MBIA and Ambac) originally insured one, usually low-risk class (or line) of bond issuer like municipalities against default, granting them the cover of the monolines' own top-notch investment ratings. In this way, such issuers could take advantage of lower interest rates, and also count on a steady demand from pension and other big funds that are prohibited from investing in concerns with lower than the highest ratings. This was a profitable, if rather dull business, until, repeating a pattern we have seen over and over again in the subprime saga, the monolines, attracted by the huge profits being made in the proliferation of the newfangled structured financial instruments, decided to get in on the act. They started to insure complex bundles of securities against default, including collateralized debt obligations incorporating subprime mortgages. They also sold "credit default swaps," or CDSs. CDSs allow investors, called counterparties, for a fee, to bet on the solvency of companies. Protection sellers receive a guaranteed payment if companies go bust, while buyers, or defaulting companies' bondholders, protect themselves from the associated losses. And because this market grew at a truly astounding rate in the last few years, the monolines' own capital bases began to shrink precipitously compared to the value of the securities they were guaranteeing. This shrinkage is of course now exacerbated by the fact that mortgage delinquencies are going up, resulting in huge losses of income for the monolines (Ambac and MBIA wrote down some $8.5 billion in the fourth quarter).

But the really dangerous thing about the monolines is that some of them are now in danger of losing that all-important top-notch investment rating. In a delicious twist of fate, the very ratings agencies that the monolines relied on to create their special market niche during their headlong flight into securitization began to threaten to take them away, alarmed that the monolines, with their shrinking capital bases, would be unable to pay off counterparties to CDS swaps (the monolines are, in turn, blaming the ratings agencies for their woes). And with the economy seemingly headed into or already in recession, the prospect of a big uptick in corporate bankruptcies is all too real. As a side note, the banks, who lent huge sums to finance private equity deals in the last few years and immediately offloaded them via structured financial products to hedge funds and the like, often agreeing to take them back in case of default, are facing that very prospect; meanwhile the market for big merger deals is drying up quickly, and the banks may be also be saddled with many loans taken out to finance these.

Back to the monolines, though: if they can't pay off investors who, after all, bet on (or took protection out in the case of) bankruptcies, the knock-on effects could be quite considerable indeed. And the poor municipalities and others who provided the core of the monolines' business for so long are finding themselves exposed to huge jumps in their borrowing costs (in the case of the New York Port Authority, from 4.2% to 20%) as the monolines scramble to shore up their capital bases. And they'll be punished all the more if they can no longer take refuge in the monolines' ratings if the monolines are downgraded. This increases the possibility of fire sales—into perhaps nonexistent markets—by firms and investors increasingly desperate for cash.

Anyway, it was after such a threat was made on January 18th that European and Asian markets were pounded. Financial markets in the United States were closed on Monday, January 21st, so the Federal Reserve, meeting in an emergency session, lowered the Federal Funds rate a whopping .75% (a similar emergency cut after the 2001 terrorist attacks amounted to only .5%) as the markets opened on Tuesday the 22d. And this in spite of the fact that the markets had already factored in a .5% cut during their regular meeting scheduled for a mere week later (which they also duly provided, bringing the Fed Funds rate down to 3%, where it will probably remain until the next meeting of the Federal Reserve Board's Open Market Committee on March 18th, unless further emergency sessions are required). Still, global markets seesawed—with huge swings, including a breathtaking one-day 600 point reversal on the Dow—all week, even as the Bush administration and Congress agreed on the outlines of a stimulus package. The second cut managed to put most markets on a more even keel, where they've pretty much remained ever since.

Meanwhile, on the cleanup front, multigazillionaire Warren Buffet has offered to guarantee $800 billion of municipal debt, appearing to, in effect, step in for the monolines. But he's not really doing that: under his plan, only quality investments will be guaranteed, leaving distressed debt to languish in the hands of the monolines. Predictably, the monolines were less than enthusiastic. Indeed, Buffet's proposal reproduces the rationale of the ill-fated Superfund: it is an attempt to separate out good investments from the bad, and so allow credit to flow to the former again, without fear of contagion from being potentially bundled with the latter in some sort of securitized monstrosity that even its financial whiz-kid inventors no longer understand. But even the monolines, desperate as they are for quick—and vast—infusions of cash to restore their capital cushions (and hence their ratings), aren't ready to sell their best investments only to hold on to the worst: in that case, their restoration of rating would almost certainly be temporary, and very short. Accordingly, the talk now is of splitting up the monolines, thereby reviving the quality of municipal debt while leaving the more exotic stuff to the mercy of the market—or the taxpayer.

Unfortunately, however, new threats are appearing on the financial horizon. Besides things like student loans, commercial property and credit-card debt, which were already being viewed with suspicion by investors, more investments that were considered safe are being shunned. According to The Economist:

[T]wo little-noticed but important bits of the market have imploded [in February], and there are fears for a third, known as closed-end municipal bond funds. In the first, vehicles sponsored by banks raise short term money by issuing "tender-option bonds" (TOBs), then use it to invest in longer-term municipal bonds and the like. Buyers have fled these programmes, in part because of worries over municipal bond insurance. The banks behind TOBs are having to buy up the unsold bonds. ... Problems in "auction-rate" securities are causing even more alarm. In this $330 billion market, long-term bonds are, in effect, transformed into short-term ones by having the interest rate reset in auctions every week or month. ... This month, however, dozens of auctions have failed as investors have questioned the quality of the assets on offer...This has come as a shock to corporate treasurers at firms like Bristol Myers Squibb and US Airways, who piled into auction-rate debt assuming it to be safe.

And that's not all. This from the Financial Times:

Financial stocks came under pressure [on Friday, February 22nd,] after Freddie Mac and Fannie Mae, the government-sponsored enterprises, were downgraded from "neutral" to "sell" by Merrill Lynch. Investors have been distracted by the bond insurance sector, but some analysts fear GSEs, which guarantee about 40% of outstanding U.S. mortgage debt, could cause a bigger headache. Merrill said the GSEs' share prices did not reflect "the severity or duration of the financial headwinds facing the companies.

Markets were relieved when S&P decided not to downgrade MBIA on February 25th, and a rescue plan for Ambac, involving major banks (who seem to be open to the idea of bailing the company out rather than risk huge losses if the monolines can't meet their CDS obligations) and regulators is due by the end of February. But no one, at this point, has a good idea of how much bad debt is out there, and how great the corresponding losses to the banks and other financial institutions will be. Accordingly, some are beginning to discuss the likelihood of taxpayer-financed bailouts, at least for subprime mortgage refinancing on the part of homebuyers potentially facing vastly higher monthly interest payments (apparently officials are confident that the banks, the Fed, and perhaps even Sovereign Wealth Funds will take care of the monolines and others at the structured-finance end of the crisis, at least for now—and during an election year). On the excellent website Naked Capitalism, Yves Smith wrote on February 14th: scheme involves getting the government on the hook, via expanding the mandate of the [Federal Housing Authority] to include refinancing delinquent borrowers. Note that this turns the previous operation of the FHA on its head. The big reason the FHA lost market share to the subprime lenders was that its lending standards were conservative and required borrowers to undergo screening (horrors!). The second one, of letting servicers write down mortgage balances in line with current market values is oddly similar to the bankruptcy law changes that heretofore the industry fought tooth and nail...

And Reuters added on the 15th: "Plans for sweeping government bailouts and wholesale rewriting of mortgage terms that were unthinkable at the start of the U.S. housing crisis are gaining traction as other efforts to stabilize the market fall short." But there is a huge problem here. The idea of government-sanctioned rewriting of contracts is one that will be resisted by investors—not to mention politicians—tooth and nail, and the threat of years of litigation will almost certainly hang over any serious plan put forward to ease the pain of borrowers, even if one were forthcoming, perhaps with the coming to power of a new administration next January.

So that's pretty much where the markets stand as this article goes to press. What about the wider economy? Well, it's clear that even opening the monetary floodgates as much as the Fed has done hasn't yet had the desired effect on the credit markets. And while key interest rates (especially LIBOR, or the London Interbank Overnight Rate) that had been impervious to the Fed cuts for a while are beginning to move back down in synch with the Federal Funds rate, the cost of buying protection against corporate default has hit historic highs, and banks are still having to squirrel away cash to cover potential losses on the one hand, and to take distressed assets they peddled to big investors, but with a guarantee in the case a market "event" occurs, back on their balance sheets (which requires them, in turn, to put down reserves to cover these sums), on the other. All these factors have contributed to a situation in which ever cheaper money is being pumped into the economy by the Fed only to be hoarded by banks and other financial institutions, or spent on safe investments like Treasury bonds (which has the further perverse effect of keeping long-term interest rates down, even as inflation continues to rise, and puts pressure on the dollar, which means...more inflation: imported goods—especially oil—will cost more).

With the Fed Funds rate at 3% (and inflation rising) the Fed is running out of room to cut. They must be hoping that the bank writedowns and CDS counterparty obligations will become acceptably transparent to investors before interest rates have to go down much further. And with the country still facing large—if considerably reduced—budget and current account deficits, and still stuck in the Iraq quagmire, there is relatively little room for ambitious fiscal policy (including bailouts?), even as the United States flirts with recession. This is all the more so given that foreign investors in Asia and the Middle East (home of several of the Sovereign Wealth Funds, by the way), who have financed these deficits for so long, are seeing their investments in the United States threatened by the market turmoil, and may become less enthusiastic about putting their money in the United States—especially as the United States "gives up," in the words of Michael Mandel, the productivity gains it made earlier in the decade (i.e. these productivity gains, which were financed by excessive credit outlays, are unsustainable, and the real economy will have to settle down at a lower level of productivity if capital inflows fall due to credit retrenchment).

One positive factor involves the fact that many companies have been so profitable for so long that many of them still have huge cash reserves with which to weather a downturn, especially if it's a short one. This no doubt has contributed to the fact that losses on the stock market have remained relatively restrained, given the potential magnitude of the crisis. And the weakness of the dollar in fact improves the outlook for American multinationals, which make a lot of their money overseas.

But optimism on the export front has its limits. First of all, there have been many reports of serious slowdowns in Asian production due to the American downturn. Whether or not Asian consumers can pick up the slack is questionable, especially since inflation rates in many of these countries is turning into a big problem, which is only exacerbated by the limited options governments have to deal with it. For example, China, whose closely controlled exchange rate with the dollar approximates to the actual peg that is customary amongst the Middle Eastern oil exporters, buys back dollars and other foreign exchange entering the country in order to keep the value of its own currency down, and so keep the export machine churning out the goods. But the only way it can do this is by paying the banks, which receive the foreign exchange from exporters, in domestic currency the banks can then lend out. That increases the amount of domestic money in the economy, which tends to produce domestic inflation. With the Fed pouring cheap money into the U.S. economy, an artificial demand in the United States for Chinese products is thereby created, and only redoubled as the Chinese continue to buy U.S. dollars.

So what are the Chinese and others doing? Well, for one thing, they are increasing their subsidies to consumers and introducing price controls. As Yves Smith puts it in another of his excellent posts (February 18th): "The Fed's rapid rate cutting leaves Asia's policy makers with few good alternatives. China and the other export-driven economies have tried to limit the appreciation of their currencies to keep their goods competitive in world markets, at the cost of higher inflation at home." However, Smith relates, "Asia's rapid growth also means price controls can't keep inflation bottled up too long."

In our December piece, we speculated that the subprime/securitization crisis may turn into a milestone of sorts, inasmuch as it could mark the beginning of the end of an era in which macroeconomic instability in Western countries, particularly in the United States, tended to be offshored onto the developing world in the form of currency crises and the like. Though this may still be true in the long run, we failed to recognize that, as is so often the case, it is the very poorest who will still bear the brunt of the pain in most economic crises, no matter what hegemon or hegemonic bloc wins or loses geostrategically in the end. Accordingly, on February 24th, The Financial Times reported that the World Food Program issued a plan to ration food aid in response to surging agricultural commodity costs. In the article, the Financial Times also noted "a new area of hunger," in which, "even middle-class, urban people" in developing countries "are being ‘priced out of the food market' because of rising food prices;" and this, in "a wide range of countries."

Now there are a lot of reasons for this, including the completely insane policy of the U.S. regarding ethanol production (which is an extremely toxic and wasteful substitute even for fossil fuels)—not to mention climate change—but there is no doubt that the kind of turbo-charged growth that is enabled by global monetary extravagance is going to contribute to a hyperactive demand for fuel. This, in turn, will put pressure on food prices even for the oil producers. From the February 25th edition of the New York Times:

In Saudi Arabia, where inflation had been virtually zero for a decade, it recently reached an official level of 6.5%, though unofficial estimates put it much higher...The inflation has many causes, from rising global demand for commodities to the monetary constraints of currencies pegged to the weakening American dollar. But one cause is the skyrocketing price of oil itself, which has quadrupled since 2002. It is helping push many ordinary toward poverty even as it stimulates a new surge of economic growth in the gulf.

So, if nothing else, the kind of monetary "shock therapy" hailed on Wall Street as appropriate for the rich countries, may well be creating further instability in some of the most pressure-cooked societies on earth (it's important to think of China in the run up to the Olympic Games here: the Tiananmen Square protests of 1989 had a lot to do with inflation). Then again, according to the Financial Times, the latest big thing for hedge funds has been betting on freight futures: that shipping stuff to and from countries—all too many of which may be caught in the kind of vice Smith referred to earlier, trading off currency depreciation for domestic inflation during periods of super-rapid growth—will provide a safe refuge in a time of crisis. Talk about the next big thing.

Larry Peterson is a member of the D&S collective. He writes a series of postings entitled "The Dull Compulsion of the Economic" on the D&S blog.

Sources: Robert F. Worth, "Rising Inflation Creates Unease in the Middle East," New York Times, February 25th, 2008; David Oakley, "Freight Futures Surge as Funds Seek Refuge," Financial Times, February 24th, 2007; Javier Blas and Gillian Tett, "High Food Prices May Force Aid Rationing," Financial Times, February 24th, 2008; Chris Bryant, "Bond Insurers' Outlook Dents Confidence," The Financial Times, February 23rd/24th, 2008; "Splitting Headaches," The Economist, February 23rd, 2008; Jeffrey McCracken, "Lending Squeeze Hits Ailing Firms," Wall Street Journal, February 21st, 2008; "Patrick Rucker, "Mortgage Industry Aid Limited By Loan Contracts," Reuters, February 20th, 2008; "Unsurance," The Economist, February 16th, 2008; Patrick Rucker, "Unthinkable Housing Solutions Now Thinkable," Reuters, February 15th, 2008; Liz Rappaport, Carrick Mollenkamp and Karen Richardson, "New Hitches in Markets May Widen Credit Woes," Wall Street Journal, February 11th, 2008; Chris Giles and Gillian Tett, "Lessons of the Credit Crunch," Financial Times, February 11th, 2007; Jacques Diouf and Charlotte Jacquemart, "die Situation ist sehr bedrohlich," Neue Zuercher Zeitung, February 10th, 2008; Michael Mandel, "Wie real war der amerikanische Wohlstand?," Frankfurter Allgemiene Zeitung, January 28th, 2008; "Buddy, Could You Spare Us $15 Billion?," The Economist, January 26th, 2008; Keith Bradsher, "Across Asia, Exporters Brace for US Downturn," International Herald Tribune, January 24th, 2008; "Whither the Great Wave?" The Economist, January 5th, 2008; David Wighton, "US Banks Scrap Plans for SIV Superfund," Financial Times, December 22nd/23rd, 2007.
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