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Michael de Portu Headshot

Realities of the Economic Crisis

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Financial fraud typically takes a long time to detect and yet, paradoxically, the tell-tale signs are (almost) always in plain sight. Whether it is Enron, Fannie and Freddie, or more recently Madoff, we are invariably surprised that we failed to listen to those who sounded an early warning or that we did not pick up on the anomalies and detect the grossly distorted picture.

Why is this so? One reason seems to be that many of us -- accountants, lawyers, bankers, examiners, and others -- tend to be more interested in what is documented than in the reality that actually exists. We want to be able to verify the accounts and how they were calculated, but we seldom apply the same energy to checking on what is readily observable.

There are interesting parallels that can be drawn with many aspects of the current financial crisis. The prevalence of obscure jargon, the arcane distinctions of form, the assertions that "only experts can truly understand this" and the proliferation of acronyms all act as obstacles to see what is readily observable. This situation is further aggravated by the numbingly large amounts that are thrown around about the cost of the rescue effort (Goldman Sachs recently tagged it at $4 trillion) or the losses we still face (reference to IMF and Roubini), and then the sudden bursts of optimism when we are told that signs are emerging that we may have reached a bottom. Which is it? Where are we? When all is said and done what will the world around us look like?

As it were, attempting to get to the reality of this crisis is fairly thankless; many of the instruments were issued offshore or privately, so much of the underlying information is not public; when the documents are available, they are lengthy and frustrating to read. This being said, enough government data, surveillance information, financial filings and prospectuses are available that illuminate important elements. The picture that emerges, while partial, is fairly striking. It of course confirms the phenomenal growth of mortgage securities in 2004-2007, the importance of sub-prime, the decline in the quality of later offerings, the crisscrossing of derivative guarantees and outright bets on how these and other instruments would perform.

But, what it also shows is most surprising. For example, the total of all forms of debt outstanding in the domestic market almost doubled between 2000 and 2008, from $27 trillion to $52.5 trillion, with mortgages representing $14 trillion of the latter. It reveals that the total value of domestic debt and exchange-traded stocks was almost five times GDP when the crisis began in the fall of 2007, which is twice the multiple that prevailed in the 1980s and one-and-a-half times that of the 1990s.

It shows that at $1.7 trillion outstanding and wrapped into various issues or vehicles containing other assets, sub-prime spawned a non-investment grade debt overhang that is too large to be absorbed by the $2 trillion junk bond and hedge fund sector. It shows that bank lending has not, as claimed, declined -- rather it is the issuance of securities has fallen off. It shows how just the top four banks account for almost half of the $7 trillion of bank debt outstanding in the market.

We also find that of the $54 trillion of credit default swaps, over 70% were created by the six top banks and investment firms. Credit default swaps are those contracts where a "protection" buyer would make regular payments to a "protection" seller in exchange for receipt of a "compensatory" payment if a basket of securities or other claims declined in value (regardless of whether the buyer had actually incurred a loss).

Several other aspects of the crisis come into clearer focus in light of this data. One is that it does not take as much as one might think to cripple a large financial institution. What matters is less the size of its balance sheet than that small portion of its equity that is readily available as, or convertible to, cash and can be diverted from the regular operation cycle.

The second aspect that stands out goes a long way towards explaining why something which started in 2007 suddenly exploded into a frenzy of wealth destruction in the fall of 2008. Individual firms' data show that the system suffered an abrupt deterioration beginning in the summer of 2008. This was partly related to loans and securities losses incurred or recognized (such as through mark-to-market) - but that the main culprit was more prosaic: it was a sudden freeze in the payments system under the dual impact of collateral calls and a flight-to-safety (overnight lending became unavailable except against top-rated securities and Treasuries).

Today, the banking system only appears to be operating normally. In reality, without the significant amount of liquidity provided by the Federal Reserve through discount lending and 28-day credits, the interbank payments system would still be frozen. What is also apparent is that low interest rates and continued anxiety have combined to produce an environment of high credit spreads -- a boon to banks which has enabled them to realize significant net interest income in 2008 and so far in 2009. This has also considerably heightened risk levels, as can be seen, for instance, in banks' Value-at-Risk measurements of their portfolio volatility.

This is a pure financial crisis - in fact a crisis of the payments system that has spread and disturbed the normal pricing mechanism for all assets and instruments (other than cash and Treasuries). It is this breakdown that appears to have triggered a drop across the entire economy - that is, one going beyond the weak spots of California and the automotive industry that had existed since 2006 - leading businesses to embark in a wholesale pullback and a postponement of major decisions.

If correct, this alternative view has implications for some of the ingredients that should be part of the cure.

Government initiatives to fight the crisis have been aimed at keeping interest rates low to ensure ample monetary supply and providing liquidity to protect the banks and encourage them to "lend and make markets." These initiatives also have the practical effect of serving to prop up prices. Assuring counterparts that financial institutions can meet demands for cash and do so without resorting to precipitous asset sales has this effect. Repurchases of mortgage-backed securities issued, or guaranteed, by Fannie and Freddie are another price boosting mechanism. Bolstering banks' capital serves to reduce the need to monetize assets for liquidity purposes -- strengthening someone's bargaining position similarly is a price boosting device.

This is consistent with a view of the crisis as a bona-fide recession to which the traditional recession-fighting tools need to be applied. In the alternative view of the crisis, however, the solution would instead hinge on finding an effective formula to cause a series of unwinds so that the paper can be removed and a settling up takes place on the commitments and counter-commitments referencing this paper. For this to actually occur and the system to resume its efficient allocation of resources through pricing, subprime prices would need to be pushed down rather than up. The pricing should be based either on recent transactions such as the sales conducted by Merrill Lynch in September 2008 at 22¢ on the dollar, or at a percentage of par as determined through a "down-case" discounted cash flow valuation. The pricing should reflect the reality that a year-and-a-half into the crisis, sub-prime asset impairments are no longer temporary and that they apply to entire issues and trading vehicles, not merely some of their tranches.

The pricing down and the purchase of sub-prime-containing paper should be implemented through an "eminent domain" approach akin to the expropriations of individual properties that take place when a road needs to be built for the common good. Pricing and the compulsory nature of the process would need to be uniformly managed. Whether to sell or not to sell, in particular, could clearly not be left at the discretion of security holders. Only a systematic removal of sub-prime paper will permit other assets to price back to normal and avoid leaving a large asset class of uncertain value to coexist alongside the new debt incurred in fighting the crisis.

While painful, this adjustment would recognize a state of fact -- that many institutions are not be able to operate independently in their current format, that a return to pre-crisis patterns of investment in sub-prime and sub-prime-related vehicles and instruments is an unrealistic expectation, and that the truly critical components of the banking system for the economy at large are their depositary and lending activities.