Superbanks to the Rescue
Keeping it real, dear reader…keeping it real…
Now we are going to see what a big mess central banks can make of things.
“Central banks seek to unblock markets,” says a Financial Times report.
On Thursday and Friday of last week, the Bank of Japan, the European Central Bank, the Bank of Canada and the Fed all began to rise to the challenge. We saw one report that said the ECB had “injected” $215 billion into the system. Others said the Fed had put either $38 billion or $58 billion at work. And a Bloomberg item this morning says that Japan ponied-up $5 billion, which is already having a “calming effect” on Asian markets. Whatever the final numbers turn out to be, it is a lot of new liquidity in a short period of time – more than at any time since the days immediately following 9/11 in 2001. Lending by the New York Fed was so vigorous that the fed funds rate fell to just 1% – the lowest rate since 2004.
Alert Daily Reckoning readers may already be suspicious.
“Now wait a minute,” they may be saying to themselves. “Wasn’t this whole problem caused by too much liquidity in the first place? Isn’t more liquidity going to make the situation worse?”
Oh, dear reader, what a joy it is to watch central bankers at work! What a spectacle! They are charged with keeping this great modern, capitalist economy going. In practice, that means keeping the bubble in speculative finance from deflating too fast. Of course, the bubble is largely of their own making – a direct consequence of the liquidity they injected after 9/11…and the subsequent EZ credit conditions throughout the world economy. And now, Ben Bernanke and the whole company of central bankers from Tokyo to London to New York is hard at work making sure that the bubble gets enough hot air.
Over the last few weeks, serious leaks have developed. First, there was the hole punctured by subprime lending. Bernanke and U.S. Treasury Secretary Hank Paulson immediately announced that this problem was “contained.” But then, the gap just kept getting bigger. Builders tumbled. Mortgage companies went broke. Not only were the subprime homeowners going into default…but so were the big packages of subprime loans. And a few hedge funds that owned the stuff were closing their doors.
The hole itself was in the U.S. mortgage market, but major rips seemed to be appearing all over the place. France’s largest bank, BNP Paribas, let it be known that it had a few subprime CDOs among the $2.2 billion in assets in three of its funds. It refused to give investors back their money, on the grounds that it could not properly price its assets, and therefore could not give its clients their share of their losses.
This revelation was expected. Nevertheless, it was important.
Many of the most sophisticated investments – such as the Bear Stearns (NYSE:BSC) “enhanced leveraged credit” fund – are now created by teams of mathematicians who presume to develop safer and higher yielding instruments by crunching the numbers in a better way. The resulting portfolios are not marked to market – because there is no ready market for these complicated confections. Instead, they are “marked to model”; that is, they are given values based on the mathematicians’ own formulae.
“Value at Risk,” or VAR, is the key phrase. But like so much else in modern finance, VAR is one part fancy modern arithmetic and two parts old-fashioned tomfoolery. Risk is not something that can be reduced to numbers, for the simple reason that you can’t know what risks the future will throw at you. The mathematicians simply swept aside this fundamental insight and replaced risk with numbers they could work with. They just looked back to see the numbers of the past and assumed that they would be more or less the same numbers in the future…and that markets would keep the numbers coming more or less when they were needed. They knew things didn’t always happen as neatly as planned, but they simply dismissed the unknown and unexpected as “anomalous.”
What happens when markets seize up is that the numbers stop. You can’t get a bid. What’s more, the numbers that made sense in the ’80s and ’90s will not fully reveal the risks in the market in 2007; even 10 years ago was before the rise of the $500 trillion derivative market, the huge, global carry trade and the invention of the neg-am, no-doc ARM. In other words, the innovations of the financial market themselves make their history-based risk assessments obsolete.
Since July 13th, investors have been reluctant to buy CDO tranches, or to finance LBOs, or to take Wall Street’s slick products at face value. Most recently, they’ve been worried about the real value of their stocks, too. This reticence has practically frozen the pipeline that pumps liquidity into the marketplace.
Of course, that is the way real capitalism works. It goes from crisis to crisis…from creative boom to creative destruction. From fully functioning, liquid markets…to markets as frozen solid as the polar ice cap in the days before global warming. From boom to bust…from profit to loss…from wealth to poverty…
But now, in step the central banks. The boom is fine, they say…but we’ll put a stop to those nasty busts. How? By providing more credit! The Fed intervened on Friday, buying up the securities that free market players didn’t want – including subprime backed mortgages.
We can’t wait to see what happens. Will this new liquidity convince lenders and speculators to stay in the game…and thus make the inevitable correction both later and bigger than ever? Or is the bubble already leaking air from so many places that the holes cannot be plugged? We’ll see…dear reader…we will see.
*** Goldman’s (NYSE:GS) Alpha fund is thought to have lost 26% so far in ’07. Citigroup is expected to announce $700 million in credit losses.
*** China’s stock markets are now worth more then China’s GDP. Bad sign.
*** “Keeping it real,” says Jules, “is what it’s all about. It’s a favorite expression in America right now. It means rising to the challenge, or something like that. There was a skit on Chapelle’s Show called, ‘When keeping it real goes wrong.’ It was very funny. People respond to some sort of challenge and get themselves beat up or put in jail.”
We see from the news that America’s imperial politicos are keeping it real. Presidential hopefuls Barack Obama and Rudy Giuliani said they would invade Pakistan, and Colorado Republican Congressman Tom Tancredo said that, if elected president, he would respond to terrorism on U.S. soil by bombing the Muslim holy cities of Mecca and Medina.
*** “I’m glad we’re moving to Florida,” said Maria.
“What are you talking about?” Jules replied. “We’re not really moving to Florida. We’re just changing our tax home in the United States.”
“I know, but I just like the idea of moving to Florida. I always wanted to live in Florida. It’s so warm. And I hate this cold, gray climate here. Give me sand, sun and palm trees. It will be nice to live in Florida, even if we don’t live there. I can always think that someday we’ll go back there, even though we’ve never actually been there. It’s nice to have a home to go to in a warm, sunny place. In London, I think it’s essential. I know a lot of people in London who dream of going to their houses in Spain, for example. They don’t actually go very often but the thought of the warm, sunny place helps keep them in a good mood. In helps them get through the cold, wet winter. And now, I’ll have a warm place to go to too.”
“What are you talking about…we won’t go there.”
“That doesn’t matter. It’s just the idea of it. And since it’s only an idea…I can imagine our home in Florida anyway I want. I think I’ll imagine a beautiful house in Palm Beach. I drove through there once. It was really stunning…those nice, elegant old houses on the beach. I’d love to live there. Right next to Donald Trump. So, I think I’ll imagine our house in Palm Beach.”
The Daily Reckoning
August 13, 2007
Short Fuse, with more views from Los Angeles…
Views from the Fuse:
*** The Democratic presidential hopefuls have taken on the mortgage meltdown, and are attempting to offer their solutions.
Across the board, the candidates mainly focused on mortgage brokers as the villains in the subprime mess.
Senator Clinton revealed her plan to “crack down on unscrupulous brokers” last week. In response, the National Association of Mortgage Brokers replied to Clinton by pointing out, “The entire mortgage system needs to be examined from stem to stern, from the home shopping phase, bankers, brokers, and lenders, all the way to Wall Street and the ratings agencies.”
They might want to swing by Washington too, during this examination of the real estate industry. Don’t forget that the excess liquidity and low, low interest rates created by the Fed made all of this possible.
CNNMoney.com quotes Brad Inman, publisher of Inman News (an on-line chronicler of the real estate industry) as saying, “I find it odd that the mortgage brokers would carry the weight of blame for this entire web of sins.”
Oh, what a tangled web we’ve woven…
*** “You could almost hear the collective exhale of relief from Wall Street on Friday, as the market dodged another red day full of distressed selling. A lot of people who needed a drink probably had one. Or two,” writes Dan Denning in today’s guest essay.
“In Latin, delirium tremens means ‘trembling madness.’ The dictionary defines it this way, ‘A serious alcohol-withdrawal syndrome observed in persons who stop drinking alcohol following continuous and heavy consumption. It involves profound confusion, hallucinations, and severe nervous system over-activity, typically beginning between 48 and 96 hours after the last drink.’
“The Fed has given the market a stiff drink to off-set the symptoms of credit withdrawal. As any good drunk will tell you, a drunk is always a drunk, even if he stops drinking. There is no cure for addiction, just a replacement of bad habits with better habits. Below the surface, what exactly has the Fed done and what does it mean for the weeks ahead?”
*** “Market watchers and history buffs will recognize the recent move by the Fed for what it really is: Moral hazard writ large,” writes Addison.
“In his 1978 classic, Manias, Panics and Crashes, Charles Kindleberger suggested that in a world where the U.S. dollar is the universally accepted currency, the Fed has a duty to serve as ‘the lender of last resort’. But they shouldn’t appear to do it willingly, lest they encourage ‘moral hazard’ – the idea that no matter what dunderheaded lending mistakes bankers make, the Fed will always step in with a ‘free lunch’ program of easy terms and free cash.
“Last Tuesday, Bernanke and company stuck to the script. They announced they wouldn’t change rates in response to market volatility caused by subprime revelations. But by Friday, the temptation was too great… and the liquidity spigots were opened wide. Friday’s record $38 billion injection was second only to the $81 billion the Fed gave away following the September 11 attacks in 2001.
“Our question now: what happens if we face a real crisis? Another terrorist attack? During this era, when the United States is supposedly at the highest economic apogee in its history, why does it take so much credit to keep the dog afloat?”
For more from Addison, see today’s issue of The 5 Min. Forecast.
*** Blackstone President and COO Tony James is keeping an eye out for debt that has been oversold in the market…
The end of EZ credit is surely going to cut down on the amount of “megadeals” in the market, says James, but that won’t deter him. “The return of opportunities we see in private equity are at least the best we’ve seen in two years.”
Tony James isn’t the only one sniffing out overlooked opportunities right now…
“I think things could get worse in the market,” says Capital & Crisis’ Chris Mayer. “I can tell you, from watching some of the action closely over this past week that it just feels like a bad market. There is lots of panic selling that seems to sort of snowball. It’s as if the market has many weak players, people on borrowed money or who are just not sure of what they are doing. When the market starts selling everything off indiscriminately, there are bound to be opportunities in the aftermath.”
The Daily Reckoning