In These New Times

There’ll never be a day so sunny,
It could not happen twice.
Where is the man with all the money?
It’s cheap at half the price!

From the Musical Oliver

agonist.org

Henry Paulson has turned into our very own Oliver now that he has gotten permission from the Congress to start peddling toxic mortgage securities and credit default swaps. Soon Old Hank is going to be out on the street corner with his bucket of goodies, glowing bright green with radioactivity. He’ll be looking for the man with all the money, willing to purchase something at half the price, or better.

The problem is, the man he’s looking for is the man he bought the sludge from in the first place. The buyers and sellers of these products are in a closed universe – the parallel banking universe of Wall Street brokerage firms, global commercial banks, and hedge funds. This is a universe of unregulated players. No one has been monitoring what the hedge funds are doing. The brokerage firms long ago convinced their regulator, the SEC, to back off in its oversight, and let Wall Street leverage itself 30:1. The commercial banks hid all their parallel universe activity out of sight in Special Investment Vehicles.

In a parallel banking universe, you get to create money – which is the same thing as creating a loan – just as if you were in the normal banking universe subject to central bank controls. Only you don’t have to keep any reserves at the central bank for the money you create, so it’s possible to generate an infinite amount of new money in the economy through your parallel banking system. The only conceivable impediment to your progress would be a central bank that in the real world raises interest rates too high. But that was hardly the problem here – the Federal Reserve from 2000 on, even until today, has kept interest rates at historically low levels, and even below the rate of inflation.

The stage was set under the Bush administration for the greatest credit expansion in the history of capitalism. In 2000, Wall Street brokerage firms had assets totaling $1.0 trillion; by the end of 2007 total assets exceeded $3.0 trillion, while equity in these firms remained minimal thanks to the SEC. The commercial banks weren’t too far behind in this growth mania, but they hid their growth in off-balance-sheet investment vehicles that were loosely regulated by the Fed. Wall Street binged on an orgy of lending, and then packaged up these loans into securities to sell to hedge funds and others. These securities totaled $1.0 trillion in 2000, and reached $4.5 trillion by the end of last year. To put this in perspective, the GNP for the U.S. economy is $15 trillion, so about one-third of annual U.S. output was at risk just from asset-backed securities whose collateral has turned out to be quite shaky.

We know some of these securities, which were mostly backed by U.S. mortgages, were sold to university endowments, pension plans, and mutual funds. But the great bulk were sold to hedge funds. I’d like to tell you how much, but nobody knows, not even the government. There has been no regulation whatsoever over the hedge fund industry. What we do know is that hedge funds were typically leveraged 30:1, and that Wall Street lent them the money to leverage themselves so they could buy Wall Street products.

None of this counts home equity lines of credit, auto loans, or college loans, which were a booming business this decade. All of these loans were securitized as well and sold to investors. Nor does it count $64 trillion (notional amount) in credit default swaps, which boils down to a net risk of about $1.2 trillion that sellers will have to pay buyers if defaults occur. The failure of Lehman Brothers is now the first major test of these derivatives.

These multiple bubbles burst last year with an Awakening Moment when two Bear Stearns funds collapsed. At that point, the market suddenly realized the risk in these assets was far greater than supposed – even deadly. The first to flee the market were the “end-users”: endowments, mutual funds, insurance companies, pension plans, sovereign wealth funds, and foreign banks. These unfortunates are just now beginning to face up to the losses in their portfolios, though as we saw with AIG, many are still in denial. One thing is for sure – they aren’t coming back soon as buyers, and for some of these assets like credit default swaps, or asset-backed commercial paper, they may never return.

Hank Paulson cannot count on state governments and municipalities to be buyers, because this sector of the economy has been badly hurt by the housing slowdown, the credit crunch, and the general economic malaise. California says things are so bad they cannot find banks to lend them enough to make payroll at the end of the month.

So that just leaves the parallel banking players to buy and sell among themselves. But this is a dramatically shrinking universe. Wall Street investment banks are gone, into bankruptcy, or into the less-than-eager arms of the giant commercial banks, or converted into commercial banks themselves. The hedge funds are imploding, in part because their existence depends on leverage, which has recoiled on them because even modest losses cause huge bites into their capital. Many of the prominent hedge funds have lost 15% to 25% of their capital last month alone. The hedge funds can’t borrow anymore, because their lenders are the very Wall Street and commercial banks in such trouble.

That leaves commercial banks like Citibank, Bank of America, Deutsche Bank, JP Morgan Chase, Goldman Sachs and a few others to wind up holding trillions and trillions of dollars of mortgaged-backed securities, credit default swaps, credit default obligations, other securities covering credit card receivables and auto loans, and corporate junk bonds. This is like a game of musical chairs where the survivors have to pick up and carry a chair on their back each time a rival drops out. The burden is so staggering no one has the energy left to play the game, much less win.

What’s been happening is that all this dead weight has been off-loaded on to central banks at first, and then directly to tax payers via the federal government. One central bank – the Fed – already reached its limit, and had to be recapitalized a few weeks ago. The U.S. Treasury has now stepped up, but a tax payer revolt has shown how difficult it will be to continue burdening the general public.

So Hank Paulson is now resorting to standing on the street corner, rattling his bucket of goodies, hoping some new and hitherto unknown source of capital will spring up. He has his Goldman Sachs lackeys already out pushing a prospectus, telling everyone that this stuff can be bought cheap and you will make a fortune one day when prices recover. The Larry Kudlows and Jim Cramers of the world are using their soapbox to tell you the same thing, but guess what – they themselves don’t own any of this dross, even though it’s been on sale for over a year now.

There are no buyers because the universe of potential buyers is imploding, and the few that are left who could buy are too stupefied with their own problems to even bother. There are no buyers because everyone can see, even if the cognoscenti won’t admit it publicly, that we are in a vicious and prolonged deflation. Everything of value is going down, and pieces of paper that are today worth only pennies on the dollar are not going to miraculously soar to par value in such an environment.

When Congress passed its $700 billion rescue bill, all eyes were on the banks who needed rescuing. No one paid attention to the buyers, because it was assumed they were out there somewhere. Eventually we will find out they don’t exist, and all that is left are a few mega-banks saturated with bad debt, and you and me as tax payers struggling to figure out how much more of their debt we can take on for them.

Oliver Twist at least got a bowl of porridge. Once the remaining big banks collapse into insolvency, dragging down hedge funds and over-leveraged corporations with them, we’re going to be scrounging on the floor for whatever scraps are left over from this debacle.