The Credit Crunch and The Insolvency Arena

Take any sampling of say, 500 Americans. Ask each of them if the language of today’s political rhetoric and public discourse through the media is too inflammatory, too mean spirited. To the last one, they would say yes. They might even go so far as to say it is worse than it has ever been.

We hear talk now of class warfare, of the cruelty of attacking the past of presidential nominees, of racial slurs and religious intolerance. Too big to fail, too many jobs to fail, too interconnected to fail, socialism!, destroying our grandchildren’s future, killing our planet! Our sampling of Americans would probably express distaste and even anger at the temperature and edge of the words in our modern video discourse.

But the modern American pundit or politician has no corner on that market. Caustic words and vitriolic rants have been a fixture of our free society all along. Take for example what John Adams said of Alexander Hamilton:

“[He is the] bastard brat of a Scotch pedlar [who] had a superabundance of secretions which he could not find whores enough to draw off.” Wow. And that guy was our president.

Or what about the impeachment hearings of the Viceroy of India Warren Hastings? Of him Richard Sheridan said:

“There is, by some foul, unfathomable, physical source in his mind, a conjunction merely of whatever is calculated to make human nature hang its head with sorrow or shame. His crimes are the only great thing about him, and these are contrasted by the littleness of his motives. He is at once a tyrant, a trickster, a visionary, and a deceiver. He reasons in bombast, prevaricates in metaphor, and quibbles in heroics.”

Acerbic speech is far from our problem. It is a sideshow; a permanent fixture of public discourse. It is the froth of the moment brought up from the brew of potent thought and visceral reaction. It should be more amusing than insulting – and ultimately it should be irrelevant.

America has collectively awakened to a crisis. Fear and a bunker mentality have choked consumer spending. It seems bad news makes people act even more conservatively, which makes things worse, which makes for more bad news. Most of what is written about this phenomenon seems to rest on intangible reasons like consumer sentiment or retail pullback. So we thought we could offer a concrete, albeit strange, example by looking to the world of primates. Don’t sigh just yet – wisdom is often found in simple things. If the last 18 months have taught us anything, economics is not a science, it is a social science. Just ask all the guys who lost billions for themselves and many, many others. They have plenty of complicated answers if you really want to listen to them. And probably some pretty little charts about ‘sharpe ratios’ and ‘beta coefficient.’

Go to the jungle and record a bunch of baboon calls. Try to figure out what each of the calls mean. This is one says ‘I am scared’ that one says ‘Where are you’ and so on. That is what husband and wife team Dorothy Cheney and Robert Seyfarth did for a year in Botswana. They wrote a book called Baboon Metaphysics.

I read it at the same time I was reading an economics book, and something jumped out. One of the discoveries of the researchers is that baboons ignore a lot of what goes on in the world as long as it sounds ‘normal’. When it sounds out of place, they really take notice. It is a disruptive moment that puts the whole group on edge. It is what I will call The Case of the Puzzled Baboons.

For example, they recorded a sequence of calls wherein a high ranking female grunts at a low ranking female, then the low ranking female screams. Now, if they played that back on speakers to the same bunch of baboons a few days later, none of them would take notice. They would simply go about their business. However, if they reversed the order of the sounds, first the scream of a low ranking female, then the grunt of the high ranking female, they all looked up. They all became disturbed, disoriented. Clearly, that was not supposed to happen…and so they took notice for the very first time.

Think about it this way; for the last 15 years, all of the economic news pouring out from news sources has never really mattered to most of us. It became white noise. Fell into the background. We heard that oil went up, oil went down. Jobs were lost, jobs were added. We heard in 2001 there was a recession but then we had a jobless recovery and everything was fine. All of the news – ALL of it – simply never mattered to us. It came to us in sequence. It sounded so normal we forgot to listen. Our lives were truly never any different one way or the other. We became accustomed to news of all sorts. We were addicted to the feeling that no matter what we heard, it really did not matter

Then in happened. The noise came to us out of sequence. This is hurting me! We know people out of work! We know of store closings, foreclosures, people in real economic hard times. Like the baboons, we looked up. Something was amiss. Consumers heard things out of order. Companies heard things out of order. The market did not behave the way the money managers wanted it to behave.

All the lectures and books about market risk? They are failing. All the computer models? They are failing. The point is, things are not happening in the right sequence. The normal order is disturbed greatly, and we all feel off balance. The geniuses on Wall Street? Most of them are young, never saw a bad deal, or a bad time. They all became numb to the news. Things were simply too big and too stable to worry too much about them. They sat in their trees and picked bugs off of each other listening to the screams and grunts around them – satisfied that it all sounded pretty normal to their ears. They are taking notice now. Our guess is that 2009 will cut another third of the Wall Street jobs from the market and P-Diddy’s White Party will be a little thinner this year in the Hamptons.

The more we hear normal things, the more we think things are normal. We forget to plan, to notice things in the marginalia. But we have perked up now. Consumers are behaving differently this time around, because this time around is truly different. In this at least, we are no different than baboons. Perhaps a few other ways too…

 

 

Facts are fickle things of course, but we can say with confidence that things are not getting better. The albatross of evaporating home equity pulls us ever downward. The storm of deleveraging in the markets seems only to beget more deleveraging. The appalling loss of our collective wealth threatens to grind our consumer based economic machine into metal shards. Left standing at the edge of the squall line is the American public, baffled, confused, angry and fearful.

The churning of the press in the last few weeks has at least been good for something. If there were any doubt before, none now should remain. Our national conversation about our economic woes is shockingly devoid of an original voice. Each new article about the state of our affairs seems little more than a recapitulation of someone else’s opinion; which itself is derivative of another’s opinion. At best, we might find a concise description of what has happened. More likely, we find a scathing tirade that devolves into political posturing. Noticeably absent are solutions.

The ferocity of the arguments push factions further a field until one side shouts ‘affordable housing is to blame’ another ‘it was the greedy investors’ and still another ‘Wall Street sold out Main Street’ and nothing is heard over the ever greater distance of their positions. We have before us now an endless parade of pious vigilantes each blasting the other for its thuggary and greed.

In his respected book The Great Crash 1929, Galbraith calls this ‘the yearning for a malefactor.’ Remember that it was after the crash but still in the middle of a crushing depression that Roosevelt assumed the mantel of the Presidency with a promise in his inaugural address to ‘drive the money-changers from the temple.’ Perhaps the most chilling observation in Galbraith’s book is this single sentence, ‘The singular feature of the great crash of 1929 was that the worst continued to get worse.’

There is blame enough to go around of course, and in the assignment of that blame we may find clues for our reconstitution. But it takes little courage to blame for the sake of blame itself. Far harder indeed it is for us to pause, to rethink our entrenchments, and to cast a new mold. 

Traditional clashes between political factions may offer a win should the cause be won. If one were to win the war on drugs for example, surely all would prosper. Or if another were to forever make solvent our entitlement programs, surely all would win too. But we must now realize this crisis is different. It is a zero sum game. The victory of one will only be at the expense of another in equal measure and neither will have made it one step closer to a solution. We are in the most proverbial of boats together. It is a mess of our own making and by our own making will we it be solved.

The moves of our Federal Reserve and Treasury in the last few weeks are gigantic in scope. Decades from now students will study 2008 when the financial markets changed, when the relationship between the government and the private sector was forever altered, and when doggedly held beliefs were shaken from their established perches.

Of course unprecedented times call for unprecedented measures, but massive actions in complex systems always create unintended consequences. What will ours be? Can the brightest minds in the world fail? How can apparently simple solutions breed terrible consequences? Easy.

Take the building of the Panama Canal. The French found the brightest among them to engage in one of the most historic engineering events of the era. They tapped their countryman Count Fedinand de Lesseps who helped build the Suez Canal to oversee the project. They tapped Gustave Eiffel (as in the Eiffel tower) to build the locks for the canal. They tapped some of the best doctors of the day to care for the thousands of workmen on the job.

And so it began. The brightest and the best all working as a team. They built huge wards with rows of beds to take care of injured or sick workers. To keep the stinging bugs and tarantulas from crawling up the legs of the hospital beds onto the patients, the brilliant French doctors had a plan. They placed each bed leg in a bowl of water. The bugs would not crawl into the bowl and swim to the legs of the beds. The solution to the problem of dangerous bugs seemed simple, even ingenious.

But the rate of Yellow Fever and Malaria among the hospital patients was soaring. Even the rate of infection of the workers in the fields was soaring. Dozens died daily. Soon hundreds died daily. The problem kept compounding until finally, more than 20,000 workers died. The French gave up. The bonds used to finance the building of the canal project were worthless. Middle class families who invested in the bonds back home in France lost everything. The smartest people, from one of the most educated countries on earth at the time, failed miserably.

Turns out, it was the law of unintended consequences writ large in the Central American jungle. As we now know, mosquitoes breed in stagnant water and transmit tropical diseases through their bites. The bowls of water meant to keep crawling bugs from reaching the sleeping patients actually served as a breeding ground for mosquitoes. The French inadvertently created an epidemic that killed people at an appalling rate. Take infected people; place them in a ward with workers who might only be injured. Place hundreds of little mosquito homes at the foot of everyone’s bed. Make sure that all mosquitoes now will carry the diseases in their blood. Make sure all patients in the ward are infected. Send the legions of infected insects out into the fields to infect more workers. Fill more wards. More bowls. More dead.

The law of unintended consequences is very real. Hard walls in a complex system force the system to find a way around. When the Treasury asked (and received) permission to bail out Fannie and Freddie, they wanted the markets to feel good about lending them money, about buying their stock, and about buying their mortgage backed securities. Instead, just the suggestion of the bailout created a crisis of confidence. If the government takes over, will it render my stock worthless? Will it make my bonds junior in importance to their bonds? The move intended to avoid a bailout, forced a bailout.

Now the government intends to buy tens of thousands of bad loans and begin a massive program of debt forgiveness and loan restructuring. What will the unintended consequences be? Will good borrowers stop paying on their loans so they can get on the gravy train? What will the unintended consequences be of the government’s move to buy preferred shares of huge banks? Instead of encouraging the banks to lend again, the move might simply delay the inevitable pain and failure of bad banks. Perhaps it will not encourage lending at all – just a round of cannibalizing consolidation.

The markets into which the Fed and the Treasury are digging their fingernails are deep, complicated, and connected globally on the lowest and the highest levels. A complex system requires us to tread with caution, to think in terms of decades not hours. Can the brightest minds in the world make mistakes? They do all the time. In the case of Panama, they killed 22,000 people without pointing a gun. Can the best laid plans fail? Of course. As the Roman playwright Titus Maccius Plautus observed a couple of thousand years ago, “things we not hope for often come to pass more than things we wish.”

With the speed of a thunderstorm and the force of a glacier, the massive deleveraging of global markets is reshaping the face of the American financial markets. The venerable system of Wall Street investment banks was carved from the map in a matter of weeks. The unwinding is not over of course. But a way forward must be found.

There will be a moment in the months and years to come, when our culture will look back and realize that it is over. That we survived a very black time and that better days are finally upon us. At that moment, without a doubt, we will have an entrepreneur to thank. An innovator. A free thinker. Teams of them in fact.

Some would argue that innovation got us into the mess in the first place. They cry out – It was the derivatives! The credit default swaps! It was those complicated and new fangled financial instruments that made all of this happen!! In a way they would be right. There is little doubt these financial innovations amplified risk to an astonishing degree rather than democratized risk as they claimed. But the answer is not so easy.

Deeper problems have been building for years. Our central bank was too cozy with our politicians and too archaic in its structure. Our affordable housing mandates were pushed too far and they injected poison into the financial bloodstream. Our energy policy was tumbling headlong into dangerous addictions. The price tag of our social aspirations outstripped the income of our tax system. Our national obsession with stuff eclipsed our cultural heritage of rugged individualism.

Not surprisingly, the creation of sophisticated financial instruments coincided with the maturation of computation. Financial wizards fed data and ran programs as fast as their processors could handle it. Currency arbitrage could be tracked and bet upon. Fluid commodity markets like oil and wheat could be understood in new and different ways. By the height of the credit bubble, Wall Street was selling a piece of a piece of a piece of a debt insured by someone who was insured by someone who owned a security. The math was unfathomable. Turns out the risk was unknowable and the damage unthinkable.

The innovations were not without benefit of course. The securitization of mortgages lowered borrowing costs for millions of people for decades. The explosion of building brought an explosion of jobs. Marketers had people to pay them. Brand builders had people to brand. Web designers had sites to build. There was money to fund the tech start ups. There were customers to buy computers and pay for internet access.

But the system was still the same. The innovations were just still the playthings of the old guard. Profits were maximized and risk was forgotten. But the bones of the system could not handle the new weight that was being created. Remember, the horse drawn buggy was improved with newer wheels, better axels, and better suspension right up until the automobile relegated it to history forever.

And so it comes to you. To us. The destructive force of unwinding is clearing out a new space upon which to build a new financial model. The task to us is to build nothing short of a new cultural identity. The architects of this new model have not yet revealed themselves. But make no mistake; the new model will be as different from the old as the car is from the buggy.

Eric Hoffer observed, ‘In times of change learners inherit the earth; while the learned find themselves beautifully equipped to deal with a world that no longer exists.’ The denizens of Wall Street and the tired politicians in Washington are beautifully equipped indeed. It is time for the learners to step forth.

The ferocity of the credit crisis has surprised everyone. Even the most pessimistic observers are a bit punch drunk that their dire prognostications are coming true. How did it happen so fast? When will the sheer speed and force of this unwinding begin to subside?

 

 

 

 

 

Maybe there is an analogue in physics. In the Wall Street Journal today, it was announced that 3 men have won the 2008 Nobel Prize in subatomic physics (they split a 1.4 prize by the way). Their accomplishments were in the prediction and discovery of something called ‘spontaneous broken symmetry.’

It seems that in any background field; magnetic, gravitational, or fluid for example, things might appear stable or symmetrical. Suddenly, with respect to the field, the symmetry is broken and things rapidly change. As folks peered deeper into the subatomic level of thing, these spontaneous breaks in symmetry were a complete surprise and revealed a great deal about the particles behind the particles.

A simple example of this symmetrical state devolving is often described as a ball sitting on the top of a hill. There is symmetry of the forces acting upon it, holding it there or not pulling it or pushing it in any direction. But it is not a stable position. Once the ball moves to roll down the hill, the symmetry of forces is broken. The ball chooses one path over all of the others, and the moment changes in a swift and dramatic fashion.

Our American economy has existed in a symmetrical state since the Great Depression. The ball has wobbled of course. It has been bumped and pushed and pulled by war, by the decoupling of the gold standard, by terrorism, by the technological revolution, and even by changes in healthcare. But seething and boiling and rolling beneath the apparent stasis of this symmetry, were the dramatic and powerful movements of the credit and banking system.

While charitable organizations told our corporations about their moral obligation to give, the corporations were in a position to give because the machinery of credit was working. While corporations bragged of their successes, the banking system was malleable enough and strong enough to provide a base on which to build. Marketers taught us about being sticky and finding our blue ocean ideas, while they feasted at the table of business profits. Politicians waxed philosophical and moralizing about our need to commit resources to social programs, all funded by the humming economic machine beneath their feat. The military paychecks we have written, the foreign aide checks we have written, the infrastructure improvement checks for highways and bridges we have written – all were cashed by the vast pool of economic prosperity managed and maintained by a functioning system of currency and credit.

And then there was a spontaneous breaking of symmetry. The forces acting, or not acting, on the ball perched at the top of the hill changed. The ball wobbled and then chose a course. We all stand surprised that we cannot stop it, that we have not been able to place it on its perch again.

But apparently, something fascinating happens at that spontaneous symmetry breaking. The researchers observed things about matter they had never seen. They identified at least three new families of quarks – building blocks of all things. In fact, the Royal Swedish Academy of Sciences said in their citation for the award; ”spontaneous broken symmetry conceals nature’s order under an apparently jumbled surface.”

And so it is that we have a moment to observe. To learn. To see beneath the things that our nation has taken for granted for decades.

Symmetry will return of course. The ball will find a new spot atop some other hill. Our economic model will follow the same fundamentals but in an entirely different way. For a moment, inside the perilous movements of this credit crisis, the clever and resourceful will observe and learn a bit more about the concealed nature of order under the apparently jumbled surface that has been our economy for years.

GenM. Lovers of leverage. Devourers of debt. Credit Couture. The Mortgagentsia.

Some clever name will be devised by some clever person that will identify the group of folks who were born just before the credit boom and lived through its drunken heyday. Everyone is sick of hearing about baby boomers. Generation X labeled a whole group as slackers. Generations y and z, or was it Generation Next, are unclear because it seems they are defined by the fact that nothing really defines them. But GenM? We can all agree that these people have lived through something powerful. Something undeniably important. Something colossal and lasting.

What then? What has this group lived through? What are they defined by?

Mortgage. They grew up among the construction trucks, the second homes, and the speculative fever. They grew up when everyone was a landlord, everyone needed a downtown condo to be fulfilled, everyone could borrow, everyone could lend. Real Estate was more than a place where you lived, it was a way that you lived. They grew up around credit cards, and car leases, home equity lines and interest only loans. They grew up in houses so large their parents could not hear them laughing or fighting or watching TV or listening to iPods or searching YouTube.

The watched all of us swim in a soup of dollars; a pool so large and so deep that it saw no end to the frolicking and fun. They grew up in a time where risk was decoupled from reward. Risk was a distant thought. Loss was something that happened to people who lived through the depression. Even our leaders were judged by their hair style or their accent or their makeup job at the town hall meeting about nothing.

GenM was taught to recycle their endless stream of water bottles while their own government devoured more resources than an entire African nation. GenM loved reality shows because a show about nothing was the only thing more interesting than a life about nothing.

GenM will be remembered by the empty condos in Las Vegas and Miami. By the hulking mansions in the suburbs around the country. By the scars on Wall Street. By the political paralysis of a government outclassed by their private sector counterparts. GenM will be remembered as the ones who looked to their leaders and found too late that they were woefully undereducated and unprepared to deal with a debilitating crisis.

But most of all, GenM will be remembered for their maniacal love of borrowing. And the rest of us will remember how we lent it to them, how we encouraged them, and how utterly we failed them.

All else pales. McCain wants to cancel the presidential debate. Americans are realizing that this news is more than just news programs crying wolf. It is a frightening time.

The logic for the bailing to commence.

Japan had a real estate bubble and a credit bubble. It popped and no one admitted it. A culture filled with stoicism and obsessed with public appearances tried to hide the poison. Keep in the belly of the economic organism. Twenty plus years later, they have still not recovered. Get it out say the proponents! The body needs to reject this toxin. Cleanse Wall Street of the bad loans by buying them with Federal money. We are not bailing out millionaires who did dumb things, we are saving our American Economic System from utter destruction. Some of the loans will go bad, some will be paid back, some of the underlying assets will be reclaimed and sold. The government (us) will be paid back at least some directly. But we will all be paid back indirectly as the economy heals, as the stock market heals, as our wealth begins to rebuild.

The logic against the bailing…

We should let them fail. They made bad choices, let them lose it all if that is what it takes. If mark to market accounting is causing the write downs and the vicious cycle of increasing borrowing costs, then change the rule. The tax payers should not put this kind of money on the line. We could all go down in this flush. Even if the plan might work, Congressional leaders are so greedy they will tack on every ugly project they can think of and the whole thing will be a disaster. The Bankruptcy Code will change, hand out programs for the poor with make us an even nation with an even greater welfare class. We will embolden Wall Street giants to act even more recklessly in the future because they will now know for certain that someone will always bail them out.

Most are not even sure what happened in the first place. It is hard to propose a fix when you don’t even know the problem. It is even harder to criticize a fix for a thing that you never even understood in the first place. By the way, no one understands this entire problem. It is too deep, too broad, too complex and too esoteric.

But once again, in our little corner of the mortgage world, we find ourselves in the center of the storm. We are going to speak at a few different business schools in the coming weeks. Still writing articles. Still going on news programs.

The idea of the bailout bothers me because I don’t like socialism. But I still must agree that it needs to be done. The cancer cells must all be cut out at once. It must be bold, large, and final. But agreeing to the bailout reluctantly still comes with these provisos.

First, no pet projects please. The arrogance and the greed of our Congressional leaders is thick and unpalatable. The plan should be clean and free from their meddling. Please, for once, could we have a congress that cares about the nation more than their re-election? No handouts, no subsidies, no down payment assistance programs, no federal judges renegotiating mortgage debt. Please.

Second, the bailout must have in its DNA the plan for its own demise. The powers cannot be permanent. The federal programs it puts in place must end soon. As tax payers, the price we pay for this bailout must surely be rewarded with the mercy to have it disappear with a whimper not a bang. Let’s buy up the loans, dispose of the debt and the assets in due haste, and shutter the operation. Let us all look back on this sad chapter as our national folly, while at the same time look back on the dissolution of this bailout program as our national pride. We came close to the flame of socialism, we all felt the heat, but we had the courage to pull back.

Third, we need to use this extraordinary moment, when all things hang in the balance, as a moment to plan for our prosperity. Legislation to prevent this type of credit bubble must be put in place – but it must not be punitive. Regulation must step a bit more into the mix, but not to a reactionary degree. Americans need to understand the dangers of leverage, but we should not be afraid to take risks.

Extraordinary times breed remarkable consensus, or engender black fear. Either condition can bring about massive change. One looks to the future for possibility and promise, the other looks to the past for blame and punishment. One will breed a new and prosperous economy and a more sharply defined national image, the other will chain us to a dissention and discord. Which will be our choice? Which will be yours?

Since January, the Dow has lost 2655 points. From 13,264 to 10,609.

Today, the Dow lost 450 points.

Like a massive glacier carving up a mountain, the credit crisis is re-scultping the face of Wall Street. Century old institutions are vanishing over a weekend. Should we worry? Should our clients worry?

We are not wealth mangers, we are not financial wizards. But the mortgage world and the credit world are the cause of all this pain – and we do understand that corner of the financial markets pretty well.

The bad news is, the pain is not over. It will come in three ways:

First, large financial institutions are too battered to handle the next round of waves. More subprime ARM’s adjusting, the pay option ARM crisis that has barely been talked about will soon hit. If there was any remaining value in the loan pools, it will soon be gone. Mark to market accounting will drive balance sheets into painful territory, short sellers will pile on, borrowing costs will shoot up – the big financials are in for more dislocation and loss.

Second, community and regional banks that behaved badly will continue to struggle. Their construction loans are dying, their development loans are dying, and their second mortgage loans are dying. To add to the woe, some of them were shareholders in Fannie and Freddie. Their cost to insure their portfolios is spiking while at the same time they have to put tons of cash away for loss reserves. Any short term borrowing they have been doing will soon be too expensive to obtain, or more accurately, there will be no one there to renew the short term debt. If they have clients who own buildings with retail tenants, the economic slowdown will pinch the tenants, then the landlords, then the banks.

Third, the insurance companies and financial companies (some already included in the company above) who handled the credit default swaps (insuring loan pools and structured investment vehicles against the risk of default) will become strained. They will not be able to pay; they will be ostracized by what is left of the lending world. They will not be able to meet obligations and the systemic shock will be immense.

The consumer debt triumvirate of auto loans, chattel loans, and credit cards will certainly make a psychological dent on the consuming public, but it will pale next to the real show.

Energy prices will continue to be a de facto growth tax until a major breakthrough forces us to shake off the old mantle and assume a new one. Part of that mantle is foreign oil and part of it is simply a connection to old technologies and old worn out solutions.

The good news? It must happen. Things will turn only after it does. Some of us would rather swallow the medicine all at once. The government cannot stretch its balance sheet any farther. The dollar is already strained to the limits of credulity. There can be no soft landing here. As we have been saying for nearly 14 months now, there was never a chance in the first place of engineering our nation out of this crisis with fiscal bailouts and monetary policy bailouts.

The other good news is that inflation will not need to be strangled out of the economy as in the past. The economy itself will slow down and drag it out by the root.

Small consolation. But the final stages of this pain can now play out. It might take another year of significant loss and pain. It might take some very valuable things with it. But at least now it can start the long walk out the door.

The math failed. The PhD’s failed. The calculus of risk was ignored. There was no democratization of debt. There was only amplification of debt. Decoupling risk from reward did not unfetter the markets for growth, it chained them to a sinking ball. Risk and reward are connected at the hip. It is axiomatic. Fundamental. You can not pledge risk free debt, for more debt, in order to insure debt, in order to make more debt without someone, somewhere having to pay.

The calculus of risk says a free market, functioning within the confines of an oganized society, must have the freedom to succeed AND the freedom to fail.