Wednesday, August 15, 2007

Wall Street: Giant Ponzi scheme? Giant poker game?

The combination of subprime mortgages, other mortgages and other items of debt into the complex collateralized debt obligations and credit default swaps invite both these comparisons, as Michael Panzner makes clear.

In essence, these forms of smashed, blended debt, sliced into tranches, are a Ponzi scheme because they have been relying on more and more people buying houses, buying bigger houses, refinancing for remodels and so forth.

These debt forms are like a giant poker game because the main bettors have been betting against the odds, especially the odds of subprime borrowers defaulting. (At the same time, as part of the incestuousness of these arrangements, creators of this debt have been depending on ratings agencies like Moody’s both to give the best possible rating on CDOs and to talk up the financial market in general, and housing market in particular, at the same time.

From Mish (whose blog on economic analysis is a highly recommended read), here’s what I mean by incestuousness:

Moody’s: “Moody’s has no obligation to perform, and does not perform, due diligence.”

S&P: “Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.”

Because of that bottom-line fact, Mish has a boatload of questions:
* How many billions of dollars will be lost because of absurd pricing models?
• How can it be that an entire system of investment decisions are based on ratings that the ratings companies tell everyone not to use for investment purposes?
• Were the ratings companies grossly incompetent or just foolish?
• Will the disclaimers of the ratings companies hold up in court?
• How long will it be before there be a court test of those disclaimers?
• Why has only a minuscule portion of subprime debt (2.1% or $12 billion of a massive $565.3 billion of subprime bonds) downgraded?
• Are the ratings companies under pressure by the banks and/or the Fed to not rerate this debt?
• Why is it that ratings companies are allowed to have outside business relationships with the companies whose debt they rate?
• Did banks realize how absurd those ratings were but look away because of greed and the ease in offloading he debt to pension plans, insurance companies, and hedge funds out of pure greed?
• Heck, did the upper echelons at the ratings companies themselves know their ratings model was flawed and look the other way out of greed?
• How long before there is a government sponsored bailout of this mess? Hint small ones are starting already. See Please - No More Help! for a discussion.
• How long before Bernanke starts cutting rates?
• How high will gold prices rise when Bernanke starts cutting?
Here's the big question: How big will the taxpayer bailout be?

But, Mish’s quote of Moody and S&P hand-washing, bad as it is, still isn’t the full story.

For one thing, these CDOs were backed not with money, but with insurance. And, just like people can “short” a stock, banks and other CDO creators could short their insurance.

Well, what’s happening right now is that a lot of bluffs are being called. Or, on the analogy above, a lot of banks and other lenders are facing the equivalent of margin calls. And, a lot of the people whose bluffs are being called are having to reveal they’ve been betting with IOUs or overrun bank drafts. And, unlike monetary deposits, these investments aren’t protected, even if made by banks. Plus, as Panzner points out, many of these types of loans were made by nonbanking entities.

Already three years ago, Warren Buffet was calling derivatives “financial weapons of mass destruction.” But Greenspan kept encouraging banks and other lending agencies to keep churning them out. Combine that with the Fed loosening the fractional money reserve requirement of banks, and you have the perfect storm.

This is why the Fed and the European Central Bank are injecting money into the system through buybacks. Banks already are thin enough on reserves that their power to fluff more credit into the system is running low. But, the Fed is actually using credit, not money, for these buybacks; banks, then, with their small reserve margins, can inflate this credit.

Stoneleigh at The Oil Drum goes into even more depth (warning, it’s about 5,000 words); if you still don’t understand too much about how much more than a “housing bubble” the subprime crisis is, and have a bit of reading time, I strongly recommend it.

One final note; our, and the world’s, Great Depression wasn’t caused by hyperinflation anywhere. Instead, the Roaring ’20s were a period of high credit inflation.

I think I’ve writeen enough on this to give you the general idea.

Cross-posted at Socratic Gadfly.