Bill Totten's Weblog

Tuesday, December 04, 2007

Magic Wand Finance

Clusterfuck Nation

by Jim Kunstler

Comment on current events by the author of
The Long Emergency
(Atlantic Monthly Press, 2005) (December 03 2007)

For those of you concerned about my sense of pride - yes, I sure got that eggy feeling all over my face last week after calling for a thousand-point Dow plunge, only to watch it put on the greatest two-day melt-up in five years. I suppose I underestimate the desperate moves of desperate people against the backdrop of an economy (and a finance sector) that remains unsound to the max despite the 700+ point sucker's rally or dead cat bounce, or whatever you want to call the giddy action in recent days.

Whatever else you think of it, there is an awful lot at stake in manipulating the collective mood of those who traffic in capital. Beneath the momentary fugue of triumphalism, markets have never been so distressed in the lifetimes of most of us living. It's not just the folks in charge of things whose legitimacy is at stake, but the system itself. When the markets really do start to manifest their true state of extreme disorder, many will blame "capitalism", not the swindlers who have been gaming it in recent years.

I would pause to remind readers how I regard capitalism in the first place: not as a belief system or a political ideology, but merely as a set of laws describing the behavior of surplus wealth and the "money" that represents it. Compound interest has worked for communists and Republicans alike. The trouble in our case today stems not from the inherent defects of capitalism which, like gravity, exerts its laws no matter how people think or feel, but from cavalier indifference to its laws. One of these is the idea that capital markets will perform credibly - within reasonable limits of risk - only if there is agreement that its tradable paper has some value. When markets work properly, fortunes are made and lost on the basis of relatively slight differentials in notions of value. In other words, people must have some idea what they are trading.

This is referred to as "transparency", meaning that those working the markets can see through the blur of daily action and know, for instance, that IBM common stock is fundamentally valuable (as back in, say, 1969) because every single office in the nation was buying IBM Selectric typewriters and paying for the service contracts that went with them. Nobody doubted that IBM had value, only whether it was worth $57 or $63 a share in a given week, or about how many Selectrics IBM might sell in the next quarter.

The action in the markets now all hinges on how certain species of "derivative" paper - certificates based on the value of other certificates - are valued. The certificates in question are mortgage-backed-securities (MBSs), collateralized debt obligations (CDOs), and other instruments based on debt rather than equity, that is loans rather than wealth. Of course, one problem associated with these things is that they exist now mainly in the forms of electrons in computer systems, represented by pixels on screens, not in paper contracts or promises to pay. Thus they are abstracted not just in derivation but in representation. The further and more crucial problem is not that there is necessarily disagreement over their value, but that, in fact, there's a growing consensus that their value is close to zero. And there is enough of the worthless crap to choke banks all over the world.

The current distress in the markets derives from the frightening recognition of this problem and perhaps even more from the efforts to conceal it. There was a ton of action on that front last week, which ignited the fools' rally in stocks. For instance, Citicorp, like many other big banks, is choking on scores of billions of dollars denominated in pixels derived from bad loans. Citicorp is in the unhappy position of not being able to cover its losses on this dreck. It appears to have liabilities exceeding its capital assets. It is even having trouble "papering over" these losses - that is, borrowing more money to appear solvent. The loan of $7.5 billion it got last week from Abu Dhabi's sovereign investment fund (a nationalized enterprise) came at the cost of eleven percent interest, a rate more commonly associated with New Jersey racketeers than legitimate bankers.

The event was greeted with triumphal sighs of relief on Wall Street. My guess is this was so only because the managers of money think it will keep appearances pasted together just long enough for them to crawl over the Christmas bonus finish line. It seems to me that there is still plenty of room left for things to go awry.

Another big spur to last week's engineered rally was the chatter about a distressed mortgage bail-out scheme by Secretary of the Treasury Hank Paulson and others. It would be nice, perhaps, if some honcho-wizard could wave his magic wand and command the adjustable mortgages to magically stand pat for an indefinite period - say, long enough to sort out the value of all those dubious MBSs and CDOs - but despite the appearance of good intentions, such a program has no practical viability whatsoever.

For one thing, nobody really knows where the actual ownership of the individual mortgages has actually landed. This is a major awful consequence of the scheme to disperse risk so widely in the creation of these derivatives. The scheme was so successful that now nobody knows which mortgage belongs to whom and how to begin renegotiating it. So any talk about restructuring these mortgages is absurd, since to do so would require agreement between the borrowers and the lenders. All the lawyers who ever lived would not be able to sort out this mess, and most of the money at stake would end up going to the lawyers now living if the process were to go forward.

All this is apart, by the way, from the question as to whether insolvent homeowners could keep up with their payments whether the rates were frozen or not, not to mention the further unsettling prospect that the interest deferred would only end up being added to their principal even while the market value of their houses spiraled ever-lower in the ongoing bubble bust.

A blanket freeze would further degrade the legitimacy of contracts between all borrowers and lenders, making it impossible to price in risk for any future lending contracts - since they would now be susceptible to arbitrary changes in terms by authorities in charge. In the meantime, a court in Ohio has already ruled that one major bank (Deutsche Bank) which thought it held mortgages there, had no legal standing to foreclose on non-performing properties {*}. Also meanwhile, public investment funds from Florida to Norway are hemorrhaging because of mortgage-associated derivatives clogging their portfolios. Meanwhile, moreover, credit markets have seized up because those supposedly holding capital can't say how much they really have, and are now terrified of loaning out "money" that might actually not be there, not in accounts receivable, not on or off any books, just ... not ... there ... anymore ...

The recognition is growing that our financial markets have been subject to mischief so egregious that there will be hell to pay. The current "distress" is the inability of the markets to function - no matter what the Dow Jones Industrial Average appears to say at any given moment. The legitimacy of the markets and those now pretending to preside over them hangs in the balance as we slide sickeningly into the holidays.


Bill Totten


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