Unintended Consequences

'A sharp tongue and a dull mind is usually found in the same head' (-Unknown).   Failure (read: bankruptcy), though cathartic and rhetorically expedient in Washington, was not then and should not now be an option.  Supporting these institutions isn‘t important because we want to prop up ill-mannered firms that contributed greatly, but not entirely, to our current predicament but because we don’t want to see all others become lost as passengers on the Titanic.  If we let the financial institutions, among others, fail, the financial magnitude of the collapse would be greater than the gross domestic product (all goods and services bought and sold) of ALL economies worldwide.  Said differently, this number would be 23x the amount of tax revenue generated in the United States in 2007.  There isn’t enough tea in China, salt in Timbuktu, diamonds in South Africa, oil in the middle east, and gold in Ft. Knox combined to rescue us from this magnitude of disaster.

Contrary to the talking heads and political insiders (Brutus and Cassious), I’m inclined to give Paulson, Bernanke, and Geitner relatively high marks for the handling of this financial crisis so far.  Presented with the above numbers, there’s absolutely no doubt in my mind that as politically distasteful as it may seem, had we not bailed out Bear Stearns, AIG, (hopefully GM) and others, this global recession would have been far worse and more devastating than anything experienced in the Great Depression.  Notable figures, astute and otherwise, have advocated two main courses of action.  First, in an effort to save the banking system from total collapse, the government should purchase (forcibly if necessary) “toxic” assets, mainly MBSs (mortgage backed securities), to free capital and loosen the credit markets.  Second, other troubled firms, large and small, should be allowed to fail and seek protection under Chapter 11.  The goal?  Salvation for those whose ark was large enough to get us to dry land, and the sacrifice of others as payment for our sins.  What most of us didn’t realize until recently is that buying MBSs from the anointed at artificially low prices (as was originally suggested by politicians and pundits) would sink the vehicle intended to save us.  

Recall magnitude.   In the interest of time and space let’s focus on the CDS’s alone.  In December 2007, when the credit markets started to stumble, the International Swaps and Derivatives Association (ISDA) estimated the total notional amount of Credit Default Swaps outstanding to be more than $62 trillion.  By another comparison, the market value of all public equities listed on all exchanges globally as of December 2007 was slightly more than $60 trillion.

Like homeowners insurance, if you could only insure against the actual value of the property at risk, this ratio would suggest that, collectively, public companies world-wide had borrowed 103%+ of their value as represented by their market capitalization.   How is it possible that all companies globally were able to borrow 103% loan-to-value so that so many contracts might be written to insure against their default?!?!?  They didn’t.  It’s actually possible to sell “naked” default swaps that represent many times the value of the debt outstanding for any given credit obligation.  A seller or buyer of a CDS doesn’t have to have a financial stake in the debt of the named insured or “reference entity” (like GM, AIG, Lehman, etc…)  The lay analogy would be writing thousands of fire insurance contracts against the value of a single house (not legal under current insurance regulations).

Who owes what, to whom and when?  CDS contracts are triggered (meaning the seller has to pay the buyer the sum of all interest and principle still outstanding for the given named obligation) when a “credit event” occurs.  Though originally non-standard, over-the-counter contracts, today there are six circumstances broadly recognized as triggers or credit events requiring the seller to make good on a credit obligation.  In their 2003 definitions, the ISDA recognizes (1) bankruptcy, (2) failure to pay, (3) repudiation/moratorium, (4) obligation acceleration, (5) obligation default, and (6) restructuring as credit events.  Note: the first "credit event" listed is bankruptcy.  If we force, allow, or benevolently (though unintentionally) push any number of major corporations into bankruptcy, these CDS obligations will be called and the gates of hell will explode open plunging us into the deepest concentric circle ever imagined.

So now let’s tie up these loose ends and draw the map of that proverbial road to hell.  The grim specter of bankruptcy looms heavily over many companies, and a great number of financial firms in particular.  The trouble among financials in particular stems from their ownership of MBSs (mortgage backed securities) that have been hard if not impossible to price in a liquid market.  The inability to price these assets creates an accounting loss and makes them look insolvent (*on paper* - though not necessarily from a cash-flow perspective).  This apparent accounting insolvency is a result of the practice of valuing these assets on a “mark-to-market” basis whereby the corporation must reflect the value of these assets at their current market value (or last value that actually traded which may not reflect the true economic reality of the instrument).  If the securities have no market price, according to current US GAAP (generally accepted accounting principles), they effectively have no value.  (As an aside, not being an accountant, I’m not entirely sure why an accounting adjustment couldn’t have been initiated through the auspices of FAS 115 or 157, which provide for the valuation of assets by other than mark-to-market means.  As far as I can tell, contrary to conventional hysteria, there wasn’t a great need to rewrite FAS guidelines for the benefit of this paper problem).  

Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization. 

Credit default swaps (CDS) are exactly what got AIG into trouble.  These contracts represent insurance against the risk of default on a debt (such as a loan, a bond etc.). The writer (seller) of these swaps receives regular payments from the buyer (in most cases, in addition to an upfront payment), and in turn assumes the risk that the underlying debt will not be repaid. In the event of default, the seller of the contract has to reimburse the buyer for the unpaid interest and the principal of the debt. 

Let’s say that some combination of the Fed, Treasury, Congress, and the President create an environment whereby anyone holding toxic MBS assets, mainly banks, must sell them at some artificially low price (fortunately that seems to be off the table for now but let’s just say)…  If the price paid is too low, the seller must write off the difference as a loss.  In many if not most cases, this loss would be significant enough to do the exact opposite of what the government wants.  A forced sale (at the levels originally bandied about - 20-50 cents on the dollar if I recall correctly) would have put the banks selling the securities almost immediately into an insolvent/bankrupt position… onto the magnitude…

Now let’s assume, not at all wildly, that the financial sector represents roughly 17%+ of all equities globally, (as it does in the S&P500 as of December of 2007) and the same percentage of CDS’s were written against that sector.  If the banking/financial sector started to fail, triggering CDS liabilities we would have a potential financial liability greater than $10 trillion… more than 14 times the amount originally granted Sec. Paulson to deal with the crisis initially.

Once the financial institutions start to fail (one or two of the large ones need to go initially – recall Bear, Lehman, Merrill, etc…), the subsequent downstream lines of credit that allow the industrial base of the United States to pay employees, suppliers, and so forth, would seize almost immediately and entirely, as it recently did.  The industrial companies would then begin to file bankruptcy (representing another 11%+ of public companies globally based on previous assumptions or another $6.8+ trillion in CDS liabilities).  Industry after industry would collapse.  Bank account balances would vanish.  Any identifiable molecular economic motion would cease in a matter of hours as if the global temperature had fallen to (absolute) zero degrees Kelvin.

The sirens--Republican, Democrat, and pundits all--who have advocated Chapter 11 for our banks, carmakers and other large companies, would have precipitated only the first ripples in the inevitable tsunami - one that would dash the entire global economy against the rocks of the aforementioned CDS obligations.  As I said at the outset, I believe that Paulson, Geitner, and Bernanke deserve quite a bit of credit for acting quickly to stem this looming disaster and allow the markets to unwind more slowly.  It’s been quite en vogue (small minded) to criticize our leaders for inaction, the changing of targets, lack of attached strings, etc… but given the magnitude, complexity and uniqueness of this crisis, I think they deserve a great deal of latitude and credit (no pun intended).